An IUL and a Roth IRA are both options that can be used to help fund a retirement or create an inheritance that can be distributed through an estate with potential tax advantages.
That is about where the similarities end for these two products.
An IUL, which is indexed universal life insurance, is a cash-value insurance policy which benefits from tax-free market gains without the risk of loss during a downturn of the market. It allows for the initial investment to be secure with the promise of conservative returns in the future. At the very least, the actual amount invested will not be lowered because of market losses.
A Roth IRA is an individual retirement account for people in the United States who meet specific income qualifications. The funds used for the IRA are after-tax dollars, which means the gains which happen within the IRA happen in a tax advantaged way. Unless you do not meet specific rules, the distributions from the Roth IRA are tax free.
Because there are so many differences between the two products, it is important to compare the pros and cons of each retirement option to determine which is the best product for your needs.
What Are the Pros of an IUL?
1. You have the potential for a high return.
With an IUL, the policies tend to leverage call options. That gives them upside exposure to the equity indexes without having the same risk of loss that other investments may provide. That means you have a higher probability of earning a return, even when compared to other types of life insurance, such as whole life.
2. There is more flexibility available to the policy holder.
With an IUL, you are able to declare how much risk you’d like to take when putting your money into the market. You have options to adjust your death benefit amount as needed. There are several riders that can be added to your policy to meet specific lifestyle or family needs in the future. Instead of dealing with a cookie cutter policy that may not fully cover you, an IUL provides flexible structures that allow you to create a customized policy.
3. You do not pay capital gains.
With an IUL, you are not paying any capital gains taxes when there is an increase in cash value with the policy. The only exception to this benefit is if the policy holder decides to abandon the policy before it matures. Other types of financial accounts for retirement funding may require capital gains taxes upon withdrawal if they are not a tax-advantaged account.
4. It can be 100% tied to a market index.
You are able to tie-up the entire cash value of an IUL into a stock market index, including a major index like the NASDAQ 100. The remainder that is left undesignated goes into a fixed account.
What Are the Cons of an IUL?
1. Most IULs put a cap on the returns that can be earned.
The insurance companies which issue this type of life insurance will often set a cap on the returns that you can earn from the index. The provider then keeps the difference between what is distributed to you and what was actually earned. For example: if your IUL has a 5% cap, but it earns 12% on the market for the year, then you’ll get the 5% added to your account and the insurer pockets the other 7%.
2. Some IULs set maximum participation rates.
Insurers have the option with an IUL to set a maximum participation rate of less than 100%. Some IUL policies have a maximum participate rate as low as 25%. This rate is then combined with the return that is earned each year. Using the 5% example from the previous point. A 25% maximum participation rate with a 5% cap would earn 1.25% for the IUL policy for the year. The insurer would then get the 10.75% remainder.
3. There are no guarantees issued with an IUL.
If you’re looking for a guaranteed return, then an IUL is not the right life insurance product for you. There are no guarantees available with this type of policy. A whole life policy does include a guaranteed interest rate, with a predictable premium, which will remain throughout the life of the policy. Your IUL may have variable returns and policy costs based on how well it performs.
4. It isn’t a 100% retirement solution.
An IUL is a middle-of-the-road risk option. Standard universal life insurance policies have lower risks, while variable polices carry higher risks. Even if you do everything right, a bad run in the market could have you losing money instead of gaining it.
What Are the Pros of a Roth IRA?
1. You are paying your taxes upfront.
When you are able to contribute to a Roth IRA, then you are providing yourself with tax-free withdrawals that can be made in the future. Of course, that also means you’re unable to take a tax deduction for contributing to a traditional IRA, so there are trade-offs to consider. For many low-income households, the post-tax contributions to create no-tax withdrawals is the better option for retirement.
2. You can withdraw your Roth contributions.
Although you are not permitted to withdraw your earnings from a Roth IRA, you do have the option to withdraw contributions without experiencing a penalty. That means you have an emergency fund available to you if circumstances arise and you should need it. It may require some discipline to avoid taking money out of it, but it will be there for use should you need it.
3. It provides a form of tax diversification.
If you hold a traditional IRA or a 401k, 403b, or similar retirement plan, then you will be paying taxes on that money as soon as you begin to take withdrawals. That may mean you’ll owe some taxes on whatever Social Security benefits you receive too. With the money you get from the Roth IRA, you can stay within your income bracket because the funds won’t count as taxable income.
4. You don’t pay taxes on growth.
No matter how much your Roth IRA grows, you don’t need to worry about paying taxes on the amount. That means your gains could be $500,000 or more and you’d still be able to access that income without worrying about changing your tax categories. You can even leave this money in the account because there isn’t a need for required minimum distributions. That means you can leave the account to a loved one and have them be able to take advantage of this savings.
What Are the Cons of a Roth IRA?
1. You have low maximum contributions.
In 2018, the maximum amount you could contribute to a Roth IRA was $5,500. For those who are over the age of 50, you are permitted an additional $1,000 in contributions as a “catch-up” contribution. To be fair, a traditional IRA is capped at the same level. That means you’ll need other retirement investment options to fund those golden years, like a 401k or 403b, which allows for $18,000 in contributions and $6,000 in catch-up funding for the 2018 tax season.
2. You must do all the setup work on your own.
An IRA is not something that most employers will offer you, and even if they do, it won’t be a Roth IRA. You must open the account on your own. It is up to you to fund the IRA each year with contributions. Many financial institutions will allow you to setup automatic contributions to make the process easier, but it is not a guarantee that you’ll max out your contributions each year.
3. There are income limits that apply to Roth IRAs.
To qualify for a Roth IRA, in 2018, your modified adjusted gross income must be less than $120,000 to make a full contribution as a single filer, head of household, or married and filing separately without living with your spouse during the year. If you are married and filing separately and lived with your spouse at any time during the year, then your maximum income is less than $10,000 – and even then, your contribution limit is reduced. For married couples filing jointly, the modified AGI must be less than $189,000. If you earn more than $199,000 as a couple, or $135,000 as an individual, you are not permitted to contribute to a Roth IRA.
4. It may be difficult to save into a Roth IRA for some people.
If you’re living paycheck-to-paycheck, maxing out the contributions available each year may be difficult. For some families or individuals, the tax deductions that a traditional IRA offer could help get a retirement savings account started or back on track.
An IUL and a Roth IRA are both good options to consider when you’re trying to save money back for your retirement. Consider each option, fund both if you wish, and you’ll get a head start on the financial planning you’ll need later on in life.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.