Annuity vs. 401(k): which one should you choose? Let’s talk about it!

We all know that we must save for our retirement. The only question is: which vehicle (or vehicles) do we choose? Annuity vs. 401(k)? Are there any other accounts? As long as we make adequate provisions for our golden years, we’ll be ok. In this article we will discuss the pros and cons of annuities and your traditional 401(k) accounts. Let’s begin, shall we?

Annuity vs. 401(K): What are the Differences?

Let’s define an annuity vs. 401(k):

Annuities

An annuity is available in many varieties and it’s a contract between you and your chosen insurance company. You give the insurance company your money and in return they give you periodic payments for a set time or until a specific event occurs (that is, the death of the person receiving the payments). 

You can choose to receive these payments every month or quarter, per year, as a lump sum, or as a lifetime income stream. These tax-deferred investments are sold by insurance companies and allow you to grow your nest egg. Then when you are ready to retire, these investments provide you with an income stream that you can’t outlive. 

As we stated before, annuities have several variations such as:

Fixed vs. Variable Rate Annuities 

A fixed-rate annuity pays out a preset, contractually guaranteed amount of income every year. This means that you have a steady income stream in retirement. But, a disadvantage is that it doesn’t allow you to hedge against inflation. So a $2000 monthly payment may seem like a lot in today’s money, but $2000 will not have the same purchasing power in the future. 

A variable-rate annuity means that income fluctuates depending on how your premium payments are invested. For example, your insurance company could invest the money in mutual funds or stock market products that fluctuate in value. So with such an annuity, you are sacrificing a certain income for potentially higher returns. 

Immediate vs. Deferred Annuities 

You can purchase an immediate annuity today with a one-time, lump sum payment, so as to begin receiving an income right away. 

However, with a deferred annuity, you can make contributions now, but you have to wait many years before you start receiving any income. 

Some longevity annuities are created to delay payments until much later in life when you’ve already exhausted your other retirement assets. 

Death vs. Life Annuities 

A death annuity also contains a death benefit for your heirs (just like a life insurance policy). With this option, your beneficiaries are guaranteed some percentage of your remaining payouts upon your death. 

In contrast, a life annuity pays out an income until you die – and no longer. The income stream is based on your contributions and life expectancy. The younger you are when you start receiving an income, then the smaller your payouts will be. 

401(K)

A 401(k) is a qualified retirement plan that helps eligible employees of a company to save and invest for their golden years on a tax-deferred basis. But not everyone can invest on a 401(k). 

You can only invest in a 401(k) if your company offers one. This type or retirement account is always tied to an employer (while this is not the case for an annuity). Furthermore, a 401(k) can be left in place if an employee changes jobs. In other cases, the 401(k) will need to be transferred to the other employer’s 401(k) program. Alternately, it can be rolled over into an individual retirement arrangement. 

You decide whether or not you want to participate in your company’s 401(k) and how much you will contribute from each paycheck (as long as you do so within the plan’s guidelines and the IRS contribution limits). 

Also, your employer may choose to match your contributions to your 401(k). Your 401(k) contributions are deducted from your salary on a pre-tax basis. So one upside to having a 401(k) is that you lower the amount you pay in current income taxes. You will not owe income taxes on the money that you contribute until you choose to withdraw it from the plan. 

Employers and Your 401(K)

You should note that only an employer can sponsor a 401(k) plan for their employees. This is because the plan is administered by the employers who run the plan in accordance with the laws and current regulations as well as the provisions of the actual plan. 

Employers decide who is eligible for the plan, how much, and when they can contribute. The employer also decides whether or not they will match their employees’ contributions and how much they will match. But, keep in mind that there are limits about how much employers and employees can contribute to the plan as per IRS contribution limits and the plan’s provisions. 

Annuity vs. 401(K): Investment Growth

Annuities are not a work-sponsored retirement plan. There are no restrictions on adding money to these accounts and you can invest whenever you please. There are also no limits to the amount of money you can invest in an annuity. As we said before, annuities are private contracts between an insurance company and a person, whereas 401(k) plans are between an employer and an employee. 

Both annuities and 401(k)s delay taxes on your investment growth. This means that you don’t need to pay on your investment gains until you begin taking money out in retirement (or if you take withdrawals). The best advantage of annuities over 401(k)s  is that they provide a guaranteed lifetime income regardless of market conditions or how long you live. 

401(k) plans are subject to market volatility and need to be aligned with your long-term goals and risk tolerance. The 401(k) offers an additional tax benefit: you can deduct your contributions from your annual taxes. This lowers your current taxable income and allows you to save more of your money tax-deferred for your future retirement. In contrast, your annuity contributions are not tax-deductible – you can only defer the taxes on your investment gains. 

Your choice of annuity vs. 401(k) is like every other investment decision you’ll make. You need to consider your overall financial situation, determine your goals and risk tolerance (either on your own or with a financial advisor), and always keep your long-term goals in mind. 

Contribution Limits 

The Internal Revenue Service (IRS) limits how much you can contribute to your 401(k). The annual contribution limit for 2019, 2020, and 2021 is $6,000 (or $7,000 if you’re age 50 or older). For the earlier years (2015 through to 2018), the annual contribution limit is $5,500 (or $6,500 if you’re age 50 or older). Additionally, your Roth IRA contributions may also be limited based on your filing status and income.

However, your annuity has no contribution limits. The only restriction is the amount of premium your insurance company is willing to accept. This may cap out between $1 million and $2 million. 

Employer Ties 

As we stated before, a 401(k) is always tied to an employer. The employer decides who’s eligible for the plan, when and how much employees can contribute. 

Annuities are not tied to any workplace. You also never have to worry about rolling your annuity funds over to another account when you change jobs. But, with a 401(k) you often need to roll your money into another employer’s 401(k) program or an Individual Retirement Account (IRA) when you change jobs. 

Protection From Market Volatility

When a 401(k) contains a greater share of stocks, then the value of the bucket is highly dependent on the stock market performance when you retire. 

For example, savers who entered 2008 with a $1 million in their 401(k) (at the start of the financial crisis) could have ended the year with only $700,000 due to downturn in the stock market returns. They had large losses in their portfolios those years regardless of how much they had contributed into their 401(k) before. 

With annuities, you never have to worry about a decline in your plan’s balance. During your accumulation phase, your insurance company invests these pooled deposits in high-quality investments to generate attractive returns. But, even if these investments drop in value, you still get your guaranteed stream of income from your fixed annuity. The insurance company carries all the investment risks. 

Fees and Commissions

The majority of 401(k) plans have annual fees attached to them. But, your plan provider is usually willing to detail what those fees are. 

Some fixed annuities are advertised as being fee-free, but variable annuities have fees that range from 2.5% to 3% each year. Death benefit riders may also come at an additional cost that can greatly reduce the investment gains in your plan. 

Apart from the fees, almost all annuities have commissions attached to them. These costs are often built into the policy, so you can’t see the commissions that are deducted every year. This lack of transparency can make it harder for you to make informed investment decisions. 

Early Withdrawal Charges 

If you’re thinking about making withdrawals from your 401(k), but you’re not yet age 59.5, then prepare for penalties. There’s a 10% federal penalty tax – unless you qualify for a hardship exemption. Furthermore, you will need an extra income tax on the distribution that you’ve taken. 

Annuities have early withdrawal penalties too – if you surrender the policy with a certain time frame. However, this penalty is often lighter and gets less harsh as time goes by. 

For example, a deferred annuity with a 5-year surrender clause may charge you 10% on money withdrawn in the first year, 8% the second year, 6% the third year, and so on. After 5 years, you have no surrender penalties left. 

Annuity vs. 401(K) Tax Treatment

Both annuities and 401(k)s provide a tax-sheltered way for you to save for your golden retirement years. You won’t need to deal with any income taxes on your investment returns on a 401(k) or an annuity until you withdraw from the plan. 

Most 401(k)s are funded with your pre-tax dollars, so your contributions lower your taxable income (which means a lower tax bill). Also, you may be able to invest in annuities through a 401(k) plan – it all depends on the terms of your plan. 

Furthermore, it’s possible to transfer a 401(k) to annuity without paying any taxes. Annuities that are funded via a 401(k) rollover are called “qualified” plans. This means that your insurance company can receive a check directly from your employer, so there’s no tax withholding. 

However, we recommend that you consult with a certified wealth professional before you make decisions about the tax implications of any retirement vehicle. 

Annuity vs. 401(K): Which One is Better for Retirement? 

Choosing the best way to save for your retirement is determined by your needs. There are many options available as annuities and 401(k)s are quite popular retirement savings vehicles. So which should you choose: annuity vs. 401(k)? Let’s consider your query some more!

Annuity vs. 401(k)

A 401(k) is a tax-deferred retirement account you can often get through your employer. You contribute money to it, customarily as a regular deduction from your paycheck. You don’t have to pay taxes on earnings contributed to a 401(k) at the time you make them. An exception to this, though, is a Roth 401(k), which you fund with after-tax money.

The money in your 401(k) is invested in mutual funds, exchange-traded funds (ETFs) or other investments as you choose. When it comes time to stop working, you can withdraw funds from the account to pay for your retirement. You don’t have to pay taxes on the money until you withdraw it. The funds in a Roth 401(k) are, again, exempt, as you’ve already paid taxes on your contributions.

An annuity is basically a life insurance policy set up to work as an investment. Put another way, an annuity is a contract between you and a life insurance company. You give the insurance company money, either in a single large premium or in small regular premium payments. In return, the insurance company promises to pay you a certain amount every month. Usually the payments start when you retire and continue until your death.

Although you can fund an annuity with pre-tax money in a 401(k), you usually would purchase an annuity with after-tax money. The earnings from the annuity are then taxable when you withdraw them. However, the initial amount paid for the annuity is usually not taxable because, like a Roth contribution, you’ve already paid taxes on it. The exception is an annuity purchased with pre-tax money. In this case, the original contribution would be taxable when you make withdrawals.

 

The Best Age to Purchase an Annuity