What is Life Insurance?
A life insurance policy is a legal agreement between you and an insurance provider. You pay premiums to the firm, which then guarantees to pay out a certain amount of money if you die while the policy is still in effect.
The most common types of life insurance are term and permanent:
- Term life insurance covers you for a set amount of time (usually 10 years). When that period expires, the insurance becomes null and void, and no further payments are necessary unless you want to renew it with another term-length contract or switch to permanent coverage.
- Permanent insurance provides lifetime death protection by paying out upon death regardless of when they were acquired or renewed (though some companies will charge higher rates for older policies).
What is an IRA?
An IRA is a tax-advantaged retirement savings account in which you may save for your golden years. Traditional and Roth IRAs are the two basic forms of IRAs.
The standard IRA has been available since 1974 and provides a tax deduction on donations (which means you don’t pay taxes on them until you remove the money). The Roth IRA was established in 1997, but it functions similarly to its predecessor with one significant difference: you pay taxes beforehand rather than receiving an instant tax reduction from Uncle Sam when you file your taxes each year. That is, if you qualify for one type over another, select wisely!
What is a 401-K?
A 401(k) is a form of retirement plan in which you may save money down for your golden years. In 2019, you can contribute up to $19,000 per year, and your employer may match that amount.
If you are fortunate enough to have an employer who provides a 401(k), it is critical that you understand how this sort of plan operates and whether it is appropriate for your situation.
How do Life Insurance and 401-Ks Differ?
There are several distinctions between life insurance and 401(k) plans. They are both retirement vehicles, but their tax consequences and investment alternatives differ.
Taxation: The money you put into your 401(k) is tax-deferred, which means you don’t have to pay taxes on it until you withdraw it in retirement. If you deposit $10,000 into a 401(k), then withdraw $5,000 when you retire at 65 and live another 20 years (until 85), only $4,500 will be taxable income—the remaining $500 was never taxed since it was put into the plan before taxes on those funds were due. With life insurance policies that are paid out upon death or maturity of the policy (such as whole life), all earnings are subject to federal income tax at ordinary rates unless they’re used for specific purposes such as purchasing a home or paying college tuition expenses for children under age 23 who are still full-time students at least half-time; otherwise those earnings will be taxed as ordinary income plus an additional 10% penalty if withdrawn early from either type of account before age 59 ½.
Life Insurance vs. IRAs for Retirement
- Flexibility: A life insurance policy is more adaptable than an IRA or 401(k). You can take money out of your life insurance coverage at any moment, without penalty. If you need money in the middle of your retirement, you don’t have to worry about paying taxes on withdrawals.
- Taxation: The money in a typical IRA or 401(k) grows tax-deferred, which means you don’t have to pay taxes on it until you remove it (and then only at ordinary income rates). Withdrawals from these accounts are also subject to obligatory minimum payouts beyond the age of 70 1/2, which is a restriction that most life insurance plans do not have.
- Investment options: The investing possibilities accessible through your employer’s plan provider are restricted with an IRA or 401(k) (or providers if they offer multiple options). Life insurance firms, on the other hand, provide greater choice when it comes to selecting assets because they are not constrained by employment norms and constraints.
Life Insurance vs. 401-Ks for Retirement
The most obvious distinction between life insurance and 401(k)s is flexibility. A 401(k) is restricted to the investment possibilities offered by your company, whereas life insurance allows you to invest in any form of investment vehicle that matches your requirements and aspirations.
Life insurance also offers bigger tax benefits than an IRA or 401(k) (k). For example, if you take out a loan against the cash value of your policy (a frequent practice), the interest paid on that loan is tax deductible as long as it does not exceed $100,000 per year—and even then, only up to 50% of your adjusted gross income is deductible (AGI). Interest paid on loans made out of IRAs or 401(k)s, on the other hand, is not deductible at all!