Annuity vs. 401(k) For Retirement

It’s crucial to understand the financial tools available to you when planning for retirement. Two of the most commonly used retirement savings vehicles are annuities and 401(k) plans. While some of their features are similar — including that both can offer tax-deferred growth — they are fundamentally different in their structure, benefits and potential drawbacks.

Here are the similarities and differences between annuities and 401(k) plans, and how each can fit into your retirement savings strategy.

Annuity vs. 401(k): How they compare

Annuities are financial products sold by insurance companies and are designed to provide guaranteed income during retirement. 

A 401(k) plan is a type of retirement account that allows you to invest over time and make withdrawals in retirement.

Both can play a role in saving for retirement, but it helps to know what their similarities and differences are ahead of making any decisions.

Similarities between annuities and 401(k)s

Annuities and 401(k) plans share several core features that make them appealing choices for those preparing for retirement. Here are a few of their similarities:

• Tax-deferred growth: Both qualified annuities and 401(k)s can offer tax-deferred growth, meaning you won’t pay taxes on your earnings until you start withdrawing the money, potentially boosting your savings over time.
• Penalty on early withdrawals: You may face penalties if you withdraw your money from a 401(k) or qualified annuity before age 59½, but there are a few exceptions. Annuities also charge surrender fees if you want to access your funds early, which eats into any payout you’d receive.
• Easy transfer of wealth: You can choose someone to receive the money in your 401(k) after you die and an annuity if you have a death benefit. This money goes directly to the person you designate as your beneficiary, which can save time and hassle.

Differences between annuities and 401(k)s

While annuities and 401(k) plans have a few similarities, they have some major differences too.

• Tax benefits: Contributions to a 401(k) are typically made with pre-tax dollars, reducing your taxable income for the year. Annuities, on the other hand, are usually purchased with after-tax money, but they can be funded with pre-tax money from a 401(k).
• Contribution limits: 401(k) plans and qualified annuities have annual contribution limits set by the IRS. Nonqualified annuities do not, allowing for potentially larger investments, though sans a tax break. If you’ve already maxed out your 401(k) contributions, you may want to use annuities as another way to ensure income into retirement.
• Investment options: 401(k) plans give you a wide range of investment options, such as mutual funds, ETFs and stocks, that you can pick from and buy directly. Annuities have underlying assets but you don’t own them or earn returns directly.
• Withdrawal rules: You can start withdrawing from a 401(k) without penalty at age 59½, while most annuities have withdrawal fees based on the date of purchase.
• Employer involvement: You can fund a 401(k) with your pre-tax income and may get contributions from your employer, which is essentially free money. Annuities, however, are bought individually through insurance companies, with no employer match.
• Payout structures: 401(k) plans offer more flexibility when it comes to taking out funds. Annuities provide a guaranteed income stream, either for life or a set period and with strict rules about withdrawals.

Understanding the pros and cons of annuities compared to a 401(k) is crucial to making an informed choice that aligns with your retirement goals, risk tolerance and financial circumstances.

Should you choose an annuity or 401(k)?

Whether an annuity or 401(k) is a better option for you really comes down to your investment risk tolerance, how much time you have before retiring and your overall retirement goals. This isn’t an either-or choice. You can have an annuity, a 401(k) and multiple IRAs, for example.

If you want high returns, a variety of investment options and the benefits of an employer matching the contributions you’ll be making, a 401(k) might be the right choice. Keep in mind that 401(k) plans offer more potential for growth, but they also carry more risk as they are subject to market volatility.

On the other hand, if you prefer guaranteed income during retirement and are less concerned with high-growth investment returns, an annuity might be a better option. Annuities come with higher fees and less flexibility though. 

Consider consulting with a financial advisor to tailor a retirement strategy if you’re not sure which option is the best for you. One strategy may include both a 401(k) and an annuity that aligns with your financial goals and risk tolerance.

Should you buy an annuity with your 401(k)?

You can also consider purchasing an annuity with funds from your 401(k), called a rollover. But purchasing an annuity with funds from your 401(k) comes with its own set of considerations.  

• Annuities are notorious for their high fees and complex contracts and are less flexible than 401 (k) plans.
• Early withdrawals from an annuity may also face surrender charges.
• The returns on annuities may be lower than other investment options, especially if you’re looking to take advantage of compounding over time.

Comparatively, 401(k) plans offer employer matching contributions, a broader range of investment choices and potentially higher returns than some annuities. You’ll still face market volatility, though, and the possibility that you may run out of money during retirement. 

Combining both 401(k) plans and annuities might give you more of a balance when it comes to leveraging the strengths of each to outweigh their respective weaknesses.
 

Annuity vs. 401(k) FAQs

• Is an annuity better than a 401k?
  

  Annuities aren’t necessarily better than 401(k)s. Annuities and 401(k)s are two very different types of investments. A 401(k) offers tax benefits, a potential employer match and you can invest over time in a variety of assets. An annuity offers a steady stream of income during retirement in exchange for premium payments earlier. Annuities typically don’t offer a tax break or employer match and returns are set by the contract.

  An annuity provides consistent income with some protection from market volatility. A 401(k) provides higher levels of growth with more exposure to volatility.

• Should I move my 401(k) to an annuity?
  

  Rolling a 401(k) into an annuity may not be the best move since annuities can be purchased outside of a retirement account and a 401(k) offers the same tax break as a qualified annuity — but with higher fees, less liquidity and potentially lower returns than a 401(k).

  If you prefer a steady stream of income in retirement, then moving your 401(k) into an annuity may make sense. Talking with a financial advisor about your goals and options would be the best move though.

• What is the best age to get an annuity?
  

  Some say the prime time to purchase an annuity is roughly age 50 to 70 because you are nearing or have reached retirement. The best age to buy an annuity, though, depends on your age, life expectancy, financial goals and the specific type of annuity. Younger people tend to prefer deferred annuities, which let funds grow until payments begin later. Older people who are close to or in retirement may prefer an immediate annuity that begins paying out within a year of purchase.

Bottom line

Understanding the similarities and differences between annuities and 401(k) plans can help you make a decision that is best suited to your individual financial situation, risk tolerance and retirement goals. While both can offer tax-deferred growth, they have distinct features and potential drawbacks. A financial advisor can help you weigh your options and make an informed decision that sets you up for a comfortable and secure retirement.