You’ve got plenty of options for planning out your retirement paycheck. If you have a workplace 401(k) plan, you may want to keep your money at work in mutual funds or index funds, earning higher returns. Alternatively, you could cash out your 401(k) and choose an annuity, with guaranteed income in exchange for more modest returns.

What’s a soon-to-be retiree to do? Unfortunately, there are no easy victors in this retirement income cage fight. Here’s what you need to know to figure out whether a 401(k) or an annuity—or a combination of both—is best for your circumstances.

 

401(k) vs. Annuity: Basic Concepts

First, let’s review some basics. If you’re a typical American worker, chances are you already have a 401(k), the near-ubiquitous workplace plan that provides valuable tax advantages on tens of thousands of dollars of retirement savings each year.

401(k)s come in two flavors: traditional and Roth. (Not all employers, however, offer Roth accounts.) Both kinds shelter your retirement investments from taxes while you’re still working, and both provide a tax break. The difference comes down to when you get that tax break: now or later.

With a traditional 401(k), you deduct contributions from your tax bill now. Money you invest grows tax-deferred over time until you begin withdrawals, usually after you reach at least 59 ½. Then you pay income taxes on withdrawals, based on your current tax bracket.

Roth 401(k)s offer no upfront tax break but reward investors with tax-free withdrawals in retirement. That’s right. Tax-free. You’ll never pay taxes on any money you take out from a Roth 401(k) as long as you’re at least 59 ½ or meet certain conditions before then.

An annuity is a type of insurance contract that generates steady income in retirement. You fund an annuity with either a lump-sum payment or payments over time, and then the company makes regular payments for a set period of time. In fact, you can hold annuity contracts in your 401(k) account, just like index funds or mutual funds.

 

Types of Annuities

Annuities get complex fast. While all annuities share certain features, such as tax-deferred growth and guaranteed payments for some amount of time, there are a few varieties to be aware of:

  • Fixed annuities offer investors a guaranteed payment based on their contributions, regardless of how financial markets perform.
  • Variable annuities allow investors to potentially increase their guaranteed payment by choosing market investments inside the annuity, much like you might choose funds in a 401(k). This introduces an element of risk, however, and unlike a fixed annuity, it’s possible to lose money with a variable annuity.
  • Index annuities—also called fixed index annuities—track a particular market index, like the S&P 500, and allow investors potentially to enjoy more growth than fixed annuities. They generally implement a cap on how much you can gain or lose.
  • Single premium immediate annuities (SPIAs) are purchased with a single lump-sum payment and repayment begins immediately. These are particularly helpful for those who are buying annuities right when they begin retirement.
  • Qualified longevity annuity contracts (QLACs) are annuities designed to help investors avoid outliving their funds and defer required minimum distributions (RMDs).

Annuities are broadly classified as immediate or deferred. Immediate annuities are generally funded with a lump sum and begin income payments immediately, like SPIAs, while deferred annuities allow you to slowly build up value through smaller premium payments, much like you would deduct contributions from your paycheck for a 401(k). As the name suggests, payments don’t begin until a date years or decades into the future.

Because each type of annuity has its unique advantages and disadvantages, interested investors should consider meeting with a financial advisor to see how these products might fit their financial goals.

 

How Are 401(k)s and Annuities Similar?

401(k)s and annuities share some important characteristics that make both attractive retirement savings options.

  • Long-term savings. Both 401(k)s and deferred annuities allow you to make contributions over time. This can be helpful for those who want to save for retirement but don’t have large sums to invest already.
  • Tax-deferred growth. The gains you enjoy in both traditional 401(k)s and annuities are tax-deferred, and you’ll only pay taxes when you begin taking distributions. And remember: The gains you experience in a Roth 401(k) will never be taxed as long as you wait until you’re at least 59 ½.
  • Early withdrawal penalties. Withdrawals taken before you turn 59 ½ generally incur an IRS penalty (usually 10% of the amount you withdraw, plus any applicable taxes). Both annuities and 401(k)s offer exceptions when you can make a penalty-free early withdrawal, like if you take substantially equal periodic payments.
  • Assets pass outside of probate. When you designate a beneficiary on a 401(k) or annuity, those assets don’t need to go through probate and can be passed directly to a named beneficiary.

 

How Are 401(k)s and Annuities Different?

For all the ways they’re similar, there are even more ways that 401(k)s and annuities differ.

  • Sales commissions. With a 401(k), employers receive no financial compensation when employees participate in the plan. But agents earn sales commissions every time they sell an annuity. Watch out, because an annuity salesperson might be more motivated to earn that commission than to help you find an annuity product best for your needs.
  • Employer match. Your employer may choose to match a portion of your 401(k) contributions. That can make a substantial difference in total account value over time. Employers cannot make any contributions to an annuity—although you may use previous employer contributions to buy an annuity.
  • Fees. As an employee, you don’t pay any fees to own a 401(k) account, although you may be charged expense ratios to invest in mutual funds and index funds in your account. There are a range of fees associated with an annuity, especially if you purchase additional riders designed to protect your initial investment and guarantee income for those who survive you.
  • Guaranteed income. Depending on the annuity type and riders you choose, you may be able to lock in payments for life, “regardless of how long both [you and your spouse] live and even if the account value falls to zero before your death,” says Mark Charnet, founder of American Prosperity Group. “For the most part, 401(k)s have no such guaranteed lifetime withdrawal options.”
  • Investment choices. “With a 401(k), you only have certain allocation choices that are dictated by the plan with no exceptions,” says Charnet. Because you choose where to buy your annuity, you can make sure it has investment options you want.
  • Principal access. If you need to liquidate your 401(k) early, you can take out a loan to avoid early withdrawal penalties. If you repay the funds within a reasonable time frame (usually five years), you’ll avoid any penalties. If you need to liquidate your annuity early, on the other hand, you could face what are called surrender charges that target large earlier-than-anticipated withdrawals. Along with income taxes and IRS penalties, you may actually lose some of the money you initially invested if you have to access your funds early. Note that depending on your annuity, you may be able to borrow after you’ve built up some amount of cash value.
  • Returns. With a 401(k), your gains and losses are uncapped, which means there’s no limit on what you stand to gain or lose on your investment. Many types of annuities cap both gains and losses. This protects your initial investment but also creates the danger of missing out on some of the market’s upside.

 

Should You Choose a 401(k) or an Annuity?

Choosing an annuity or a 401(k) is rarely an either-or situation. That said, there are some general rules of thumb to consider.

If you’re already maxing out your 401(k) and IRA for the year and you still want to save more for retirement in a tax-advantaged account, you could put any additional savings into an annuity. “You should always max out your 401(k) first and then spill over [your additional savings] into an annuity,” though, says Renee Pastor of Pastor Financial Group.

If you’re worried about outliving your savings, an annuity with a living benefit rider might be an option worth considering, says Charnet. Living benefit riders can help you guarantee certain amounts of payment, which are particularly useful for variable annuities that otherwise would have no assured rate of return.

Outside of those situations, though, opting for a combination of both a 401(k) and an annuity might be the right choice if you want to shore up a guaranteed income stream while also leaving room for upside potential through the stock market.

“Many people want to have some portion of their money where they can be certain they’re going to get their retirement paycheck regardless of what’s happening in the market,” says Pastor. They might, for instance, want to have all of their basic needs covered by Social Security income and guaranteed annuity payments. “To achieve that, we’ll roll over some, or all, of a 401(k) into either a variable annuity with a living benefit or an indexed annuity with a living benefit.”

 

The Bottom Line

As you decide what investment vehicle might suit your needs best, remember that there’s no choice that doesn’t come with risks.

“There are always risks when investing money, and this includes your 401(k),” Charnet says, especially since 401(k)s don’t have any type of built-in principal protection like many annuities do. While annuities do run a risk of the backing insurer reneging on their promise to continue payments, these policies are in turn insured by other insurers and state policies.

However, because this decision is incredibly complex and will involve weighing the pros and cons of certainty, income levels and even taxes, don’t be shy about asking for help.

“The best advice I always say is to seek out a trusted financial advisor who is proficient with annuities [to] offer a fair and unbiased point of view on retirement income and legacy planning before considering a retirement rollover,” Charnet says.

 

Author: E. Napoletano & John Schmidt
Source: © 2021 Forbes Media LLC.
Retrieved from: https://www.forbes.com/
FINRA Compliance Reviewed by Red Oak: 1589663

 

Fixed Annuities are long term insurance contacts and there is a surrender charge imposed generally during the first 5 to 7 years that you own the annuity contract. Withdrawals prior to age 59-1/2 may result in a 10% IRS tax penalty, in addition to any ordinary income tax. Any guarantees of the annuity are backed by the financial strength of the underlying insurance company.