Financial peace is the cornerstone of any family. But how do you achieve it when there are so many options for financial wellness?
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The two most popularly debated ways to prepare your family for financial wellness are 401Ks and life insurance. Many people think they are mutually exclusive, when in fact, they complement one another.
Here’s everything you should know.
Table of Content
What is a 401K?
A 401K is a retirement plan. You contribute to it monthly in predetermined amounts. The money comes out of your paycheck pre-tax, reducing your tax liability. Your funds also grow tax-free, and if you withdraw the funds in retirement, you pay taxes at your retirement tax rate, which is lower than their current tax rate for many people.
When do you Use a 401K?
A 401K is meant for use while you’re alive. It’s a retirement fund, which means it’s money you saved during your working years to support you when you no longer work.
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Typically, if you wait until age 59 ½ or older to withdraw the funds, you won’t pay any penalties or fees. You’ll pay only the taxes you owe at that time according to your current tax bracket. But there are even exceptions to that.
If you have a Roth 401K, you pay taxes before you contribute the funds, then your contributions and earnings grow tax-free. Your withdrawals are also tax-free. There are benefits to doing it both ways, but the funds are meant for when you are alive, no matter which retirement account you use.
What is Life Insurance?
Life insurance is generally a death benefit or money you leave behind for your loved ones when you die.
There are two types of life insurance – term and permanent life insurance.
Term life insurance is suitable for a specific term. It protects your family should you die unexpectedly during that time. Say, for example, you have a 30-year mortgage. You might take out a term life insurance policy to cover the total mortgage balance, so if you die before the mortgage is paid off, your family can still live where they are most comfortable.
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Permanent life insurance also offers a death benefit, like term life insurance, which also offers a cash value. This is where many people confuse retirement funds and life insurance. They assume since there is a cash value, life insurance could replace a 401K.
This typically isn’t the case, but they can complement one another.
Comparing Life Insurance vs. a 401K
Now let’s look at the two account types side-by-side. Here’s what you should consider.
Steady Returns
There’s nothing more magical to hear than you have steady returns, right? Especially when you’re talking about retirement funds.
But when you compare whole life insurance vs. investing in a 401K, only one account is steady, and that’s life insurance.
Whole life insurance offers a guaranteed rate of return. You get the same rate of return whether the market is up or down.
A 401K doesn’t offer that same guarantee. You might invest in something that performs really well or an investment that falls apart, leaving you with nothing.
Access
Of course, a key component of where you should put your money is how easily you can access it. Liquidity isn’t something used to describe retirement funds until retirement age, but life insurance can be liquid at any time.
Here’s what to think about.
How soon will you need the funds? If you see yourself needing access to the funds before age 59 ½, don’t put them in a retirement fund. While you may be able to access the funds earlier, you’ll pay a 10% penalty fee or interest if you borrow the funds rather than withdraw them. Either way, you lose out on compound earnings and lower your total retirement fund.
With life insurance, you can borrow against your cash value at any time. There’s no minimum age or any other specific requirements. Plus, you continue to earn the same rate of return on the original balance, not the balance after you withdraw funds.
Certainty
No investment is 100% certain, but life insurance is much more certain when compared to life insurance vs. 401K, thanks to the guaranteed rate of return.
401K investments could be all over the board. There’s no guaranteed rate of return, so you could have a great balance one day and next to nothing a few days later. It happens that fast.
You can take more risks with a 401K, which may result in higher returns sometimes, but it also puts you at a much higher risk for major losses.
Choice
When you’re investing in a 401K, you might have some say in where your funds get invested. Each plan sponsor has different options to allow you to choose what you’re comfortable investing in.
Life insurance doesn’t offer that option, but you get a guaranteed rate of return in exchange, so you don’t have to worry about where your funds are invested.
Pre-Tax Dollars or Not
When you invest in a 401K, you invest pre-tax dollars (typically). This lowers your tax liability today and potentially reduces how much you pay in taxes on the funds if you are in a lower tax bracket during retirement.
Funds invested in life insurance are after-tax, but your contributions and earnings grow tax-free just like they do in a 401K. You’d owe taxes only on any earnings above the contributions when you withdraw the funds.
FAQ – Life Insurance vs. 401K
Is it better to have life insurance or a 401K?
It’s not a matter of whether life insurance or a 401K is better. Instead, you should have both. A 401K provides you with income during retirement, and life insurance protects your loved ones when you die. A whole life insurance policy offers a cash value that you can use to supplement your retirement funds, but you shouldn’t play on living off the funds in retirement. If you use up your cash value and don’t repay the funds, you surrender your death benefit, leaving your loved ones with nothing.
Can I use my 401K as life insurance?
Your 401K becomes a part of your estate when you die. Your beneficiaries named on the policy will receive the funds. Can they be a replacement for life insurance?
It depends on the value of your 401K and how fast the 401K sponsor will release the funds to your loved ones. If the estate goes into probate, your loved ones could wait months or years to get the money, leaving them without funds to cover your final expenses plus any other expenses they incur upon your passing.
Can you roll over your 401K to a life insurance policy?
Technically you cannot roll over a 401K to a life insurance policy. If you need to buy life insurance and don’t have the funds, you might borrow from your 401K to fund your life insurance with a 401K, but you must pay them back with interest.
If you withdraw funds from your 401K during retirement, you can do what you want with the funds, but if you withdraw before age 59 ½, you will pay a 10% penalty plus the taxes you’d owe on the funds.
Final Thoughts
Is a 401K or life insurance better?
It depends.
In a perfect world, you’ll have both. Your 401K gives you funds for living during retirement, and your life insurance protects your loved ones when you die. However, your life insurance may also supplement your retirement income if you use the cash value while you’re alive.
