Is there a difference between 401(k) and life insurance?
As you plan for your retirement, you must consider how your decisions now will impact your finances later. In your research, you’ve probably heard a lot about 401(k)s and life insurance. These are two financial products with very different purposes. Thus, it is quite common and natural for people to pay into both their 401(k) and their life insurance.
While life insurance helps you support your dependents after you die, a 401(k) is a type of retirement savings account that shields you from taxes. Let’s explore these two products in detail and then compare their features.
What is Life Insurance?
If you purchase life insurance, that means you are a life insurance policyholder. As the policyholder, you must choose beneficiaries who will receive the death benefit if you die while the policy is in effect. Essentially, you pay a monthly premium to ensure that the people who depend on your income, such as spouses and children, are financially secure if you die. Aside from the dependents’ living expenses, the death benefit is frequently used to pay excess medical bills and funeral costs for the policyholder.
Of course, there are many different types of life insurance. The two main ones are permanent life insurance and term life insurance. There are a few variations of these, this isn’t an exhaustive list.
Permanent Life Insurance
Permanent life insurance is supposed to last your entire life. That means that your beneficiaries are guaranteed a payout when you die. Some of the elderly might benefit from this model if they still support people with their income. However, this option is rather expensive if you’re young.
Term Life Insurance
The most common type of life insurance is term life insurance. As you can tell from the name, it lasts for a fixed term – typically 20 years. While term life insurance premiums are cheaper, be warned, your beneficiaries will not receive a death benefit if you die after the term expires.
Pros
1. Provide for your dependents
If you pass on prematurely, you don’t want to leave your family out to dry. Especially when you’re younger and you have less money saved. The death benefit from life insurance will help your spouse or your children pay their bills.
2. Tax benefits
Fortunately, your dependents won’t need to pay taxes on the death benefit. However, if you don’t name a beneficiary your death benefit is sent to your estate where it will get taxed.
3. Covers death expenses
Aside from their bills, which your dependents might need you to pay for regularly, the death benefit is frequently used to pay other expenses. These include funeral costs, debts, and outstanding hospital bills. In fact, should you become severely ill, you could take out part of the death benefit to pay for your medical bills while you’re still alive.
Cons
1. Life insurance is expensive
Aside from age, there are further factors that could render your life insurance more expensive, including your health status and gender. Men tend to pay higher premiums. Moreover, if you’re of poor health, then you have a lower life expectancy thus boosting your premiums
2. It’s not an investment instrument
A common misconception about life insurance is that it can be used as an investment vehicle like a 401(k). While certain life insurance plans like variable life insurance invest your premiums into mutual funds, this is hardly comparable to a 401(k). Since those funds only have a small upside, this strategy could backfire. Life insurance is about providing security to your dependents and giving yourself peace of mind. In this case, you should prefer stability.
What is a 401(k)?
As one of the most common retirement savings plans in the United States, a 401(k) offers many tax advantages to individuals looking to invest their savings. Typically, you arrange this plan through your employer and contribute a portion of your salary to it every month. However, you can also set up a 401(k) plan if you’re self-employed.
Investors can add $20,500 per year as of 2022. However, those over 55 get an extra $6.500 of breathing room to help them catch up.
Pros
1. Lowers your taxable income
You’ll love the fact that any payment you make to your 401(k) is tax-deductible. That means if you make $5,000 in a month and contribute $1,000 to your 401(k), your taxable income for that month will be $4,000.
2. Employers might match your contribution
To attract employees, many companies offer to match up to 100% of your contributions at a certain percentage of your salary.
3. Easy to use
Once you start a new job, employers will provide you with a form that lets you easily check a few boxes and opt into your 401(k). All you need to do is indicate what percentage of your salary you want to contribute.
Cons
1. Picking investments isn’t easy
As markets are always variable, it’s difficult to determine which investments to keep and which to cut loose. You could always mitigate your risk by picking ETFs or other managed assets. Furthermore, financial advisors can help you out with your decision-making.
2. No access to funds before 55
Since this is a retirement savings account, you can’t take any money out from it until you turn 55. Fortunately, you are always allowed to transfer your 401(k) from one employer to another.
3. Limited contributions
As we mentioned earlier, you are capped at $20,500 in contributions per year, unless you’re over 55. This type of structure might not be optimal for those who suddenly find themselves with a lot of money to invest in a small amount of time.
Life Insurance vs. 401(k)
The difference between life insurance and 401(k) is relatively straightforward. Payments from the 401(k) will come to you when you retire. Payments from life insurance will come to your dependents after you die. A 401(k) is a legitimate investment instrument while life insurance is a backup plan to help the people you support in the event of your death.
Features
You can automatically transfer a portion of your paycheque every month into your 401(k). This payment is tax-deductible. By contrast, life insurance requires you to pay a monthly premium. If your employer provides your life insurance, then the premium is deducted from your paycheque just like your 401(k).
Since a 401(k) is an investment account, you’ll likely be able to reap the benefits after your retirement. However, with a life insurance plan, you may never reap the benefits of your premiums. That’s because life insurance often has a fixed term. Moreover, the insurance payout is only activated after you die, so it’s your beneficiaries who might see the money.
Taxes
While both 401(k)s and life insurance premiums are deducted from your paycheque, only the 401(k) deductions provide you with a tax shield. On the other hand, the death benefit from a life insurance policy is not taxable unless it doesn’t go to your beneficiaries.
Retirement
The whole point of a 401(k) account is to help you plan for your retirement. The returns that you earn from your investments can compound over time and investing a few thousand a year can easily turn into a million dollars after enough time. However, you won’t be able to withdraw money from your 401(k) before you turn 55.
Life insurance is not a retirement savings plan, it’s intended to support your dependents if you die. You could withdraw money from the plan beforehand, but you will face stiff penalties. This is often done by taking out loans against the value of the death benefit. Alternatively, you could take out a life settlement to recuperate the cash value of your life insurance policy.
Should I get both?
Yes. Simply put, life insurance and 401(k) address different problems. Planning for your retirement is important, and a 401(k) is a great way to fulfill your plans. While retirement is a certainty, life insurance helps cover you in the case of a catastrophe – you dying prematurely. You want to feel secure knowing that your dependents will be looked after in case you perish. But you also know that you want to live comfortably in your retirement while paying less in taxes.