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To live comfortably in their later years, many people don’t count on Social Security to provide the income they need in retirement. This is why many contribute to an employer-sponsored 401(k) plan or a self-funded individual retirement account (IRA). But while these are two widely popular options, there’s another way to receive income in retirement. Surprisingly, there’s a group of individuals who receive regular income from a lesser-known product called a 501 k retirement plan.

If you want another income stream in your later years, here’s what you need to know about this retirement alternative.

501k definition

Most people have never heard of a 501(k) retirement plan. This is because a 501(k) isn’t an actual retirement tool. Rather, it’s a vehicle that can be used to supplement retirement income.

In reality, “501(k)” is simply a creative term coined by Ted Benna to describe a “dividend paying whole life insurance policy.” Benna, who is also known as the father of the 401(k), advocates the 501(k) plan as a better, safer strategy for generating future income.

For the sake of this article, we’ll use the terms “501(k)” and “dividend paying whole life insurance” interchangeably.

A dividend paying whole life policy is a type of permanent life insurance. This is how life insurance works: You pay a monthly premium to an insurer, and in exchange, the company or insurer pays your beneficiaries a death benefit after you die.

A dividend paying whole life insurance policy, however, differs from standard whole or permanent life insurance because these policyholders also receive a share of their insurer’s annual profits (dividends).

Depending on the insurer, you’re eligible to start receiving these dividends after owning your policy for two years.

These policies are also unique because they accumulate a cash value while the policyholder is alive. In addition, policyholders earn interest on their cash value. Both factors result in higher dividends later on.

You can take your dividends as cash to supplement your income, reinvest dividends, or apply dividends to your premiums.

If you choose this policy to supplement your retirement income, a financial planner or advisor will use a chart to estimate your future dividends based on your current age, your retirement age, and the amount of your premium. Keep in mind that dividends can vary from year to year based on company profits.

But let’s say your policy amasses a cash value of $200,000 by the time you are ready to retire and your insurer pays an average annual dividend of 6.75% — that’s a payout of $13,500 a year, the equivalent of $1,125 of supplemental monthly income in retirement.

501k vs 401k

The main difference between a 501(k) and a 401(k) is that the latter is an employer-sponsored retirement account.

When you enroll in your company’s 401(k), you choose a percentage of your earnings to contribute to the plan, and then your employer deposits these pre-tax contributions into your retirement account. Depending on where you work, your employer may also match your contributions up to a certain percentage.

A notable difference between a 401(k) and a 501(k) involves annual limits. In 2018, the 401(k) contribution limit is $18,500, or $24,500 if you’re 50 or older, according to the IRS. There is, however, no limit to how much you can contribute to a 501(k) plan or a dividend paying whole life policy.

Also, when you receive income from a 401(k) in retirement, you’re required to pay taxes on this income. Dividends you receive from a whole life policy, on the other hand, are tax-free. The IRS views dividends as a return of premiums, so you won’t owe taxes as long as the amount of your dividend doesn’t exceed what you paid into the policy for that year.

Another feature that sets a 501(k) apart from a 401(k) is the ability to pull money from the cash value portion of your whole life policy at anytime, without penalty. You can pay back what you take out of the policy, or not.

If you don’t pay back the policy, however, the insurer deducts this amount from the death benefit paid to your beneficiary.

This is different from a 401(k). If you take money from this account early — before the age of 59 1/2 — you’ll generally have to pay a 10% penalty plus income tax on the withdrawn amount.

Why Consider Other Alternatives?

Retirement approaches fast. And sometimes, Social Security benefits and income from a traditional retirement account don’t provide enough money to support your lifestyle. So it’s important to consider all savings alternatives and look into multiple ways to prepare for the future. The more you’re able to diversify your money, the better.

With that being said, if you have a 401(k) plan or an IRA and you’re currently maxing out your annual contributions, talk to a financial advisor and ask about a dividend paying whole life insurance policy.

The truth is, you can never go wrong with an additional stream of income.

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