401k vs Annuity: What’s the Difference?

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Updated on Friday, January 31, 2020

While annuities and 401(k) plans satisfy the same goal — investing for retirement — there are major differences between these two vehicles. Annuities and 401(k)s feature separate fee structures, varying contribution limits and different withdrawal rules. If you’re trying to decide how to save for retirement with a 401(k) or an annuity — or both — it pays to understand their similarities and their differences.

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Annuity vs 401(k): How are they different?

The differences between annuities and 401(k) plans start to emerge when you look at their overall structure, withdrawal rules and fees.

  • Overall structure: A 401(k) is an employer-sponsored, tax-advantaged investment account. You can choose the sorts of investments you make with money in your 401(k) account. An annuity is an investment contract, typically with an insurance company. You have no control over what sort of investments are made by the annuity company.
  • Withdrawals: You may start taking 401(k) withdrawals at 59 ½ years old, and IRS rules require you to start taking distributions at age 72. Annuity withdrawals, however, can start whenever you wish, depending on the type of annuity you select. You may take withdrawals immediately or defer them to a later date.
  • Fees: The fees on 401(k) plans are usually no more than 1%, while annuity fees can climb much higher.

Annuity vs 401(k): Overall structure

The defining characteristic of a 401(k) plan is that your employer sponsors the plan (and, in some cases, matches your contributions) up to a limit. Your contributions to a 401(k) are deducted from your paycheck each pay period. These contributions are invested in a portfolio of your choosing, where they will grow tax-free until your retirement.

An annuity is a contract taken out with an insurance company or investment firm. You agree to make a lump sum payment or series of payments to the company, and they guarantee to provide you with a stream of income.

Before you retire, the money you put towards your annuity grows tax-deferred through a particular investment strategy that’s chosen by the company. When it’s time for you to retire, you stop making payments and begin to receive your stream of income.

Depending on what type of annuity you select, that stream of income can continue until you die, guaranteeing that you won’t outlive your retirement funds. The amount of customization available for annuities is a key contributor to their reputation for being confusing financial products. There are three types of annuity:

TypeInterest RateLevel of RiskAnnual Rate of Return
Fixed AnnuityGuaranteedLow, similar to a CDTypically 3% to 5%
Variable AnnuityDependent on the investment portfolio selectedHigher, similar to a 401(k) or IRABased on your investments
Indexed AnnuityDependent on the investment index selected, but usually has a guaranteed minimumMediumBased on your investments, but has limits to your potential losses and gains

Annuity vs 401(k): Withdrawals

With a 401(k) plan, the rules governing withdrawals are straightforward: You generally cannot make withdrawals until you are 59½  years old, or else you’ll face a 10% early withdrawal penalty. You are required to start taking minimum distributions at age 72.

Annuities let you choose from a variety of different withdrawal options:

  • Deferred annuity: These annuities do not start paying out right away, giving your initial payment time to grow — called the accumulation period.
  • Immediate annuity: With an immediate annuity, you can start to receive your money right away — you’re essentially swapping a lump sum for a stream of future income payouts.
  • Payment terms: You can choose to have your payments spread out for a fixed amount over a set period of time, like monthly payments over the next 20 years, or you could choose for the payments to last as long as you live.
  • Lump sum payment: You can also take out your money as a lump sum, although if you do that before you turn 59 ½ years old, you’ll get slapped with a 10% penalty.

Annuity vs 401(k): Fees

Annuities are known for charging fees that are higher than 401(k) fees. According to financial research company BrightScope, however, most large 401(k) plans charge no more than 1% in fees. Common fees associated with 401(k) plans include:

  • Investment fees: An annual fee that covers the cost of managing the investments in your plan’s portfolio, such as mutual fund fees or trading commissions for ETFs, stocks and bonds.
  • Plan administration fees: An additional fee to cover the costs of managing the plan, like account statements and educational materials.
  • Individual service fees: Typically charged for using special features offered by the plan, like rolling over your 401(k) investments into an IRA.

With annuities, there is a laundry list of fees that runs much, much longer, and the fees you end up paying can widely vary based on the type of annuity you select. Typical fees associated with them include:

  • Commissions: This is a fee charged by the agent that sells you the annuity; it’s usually built into the price, and not highlighted in the contract. Annuity commissions typically range from 1% to 10% of your total contract value, depending on the annuity type.
  • Administrative fees: These annual charges cover the costs of managing the plan, commonly assessed around 0.3% of the value of your annuity contract or, alternatively, as a flat fee.
  • Surrender charges: This fee could be charged if you withdraw funds over your set payment amounts before a certain time period. They could be as high as 7% of your total annuity contract value.
  • Mortality expense: This fee aims to reduce the risk for the insurance company, and can range from 0.5% to 1.5% of the policy value per year.
  • Investment expense ratio: For variable annuities, this fee covers the cost of managing investments. They could climb to more than 3% per year.
  • Other fees: Transfer charges, distribution charges, third-party transfer charges, contract fees and underwriting fees are only a few of the other fees possibly charged for an annuity.

Annuity vs 401(k): How are they similar?

The tax treatments of 401(k) plans and annuities are where the two products begin to offer similar benefits, including tax-deferred growth.

With a 401(k) plan, tax treatment highlights include the following:

  • A traditional 401(k) offers tax-deferred growth with contributions taxed the same year distributions are made.
  • For a Roth 401(k), growth is not taxed but the contributions are taxed the same year that they are made.

Meanwhile, with annuities, tax treatment highlights include:

  • Gains on annuities are tax deferred.
  • Payouts you receive on your annuity are taxed as regular income when your annuity is funded with pre-tax money.
  • Gains are only taxable if the annuity was purchased with after-tax money.

The rewards of annuities

While many financial advisors warn of the potential pitfalls of annuities, they do offer key advantages:

  • Longevity insurance: The option of having a steady stream of income until your death is one of the biggest incentives for people who are looking to open an annuity. It’s a type of longevity insurance that most financial products designed for your retirement years simply don’t offer.
  • No caps on contributions: While the IRS limits how much you can contribute to your 401(k) plan each year — in 2020, for example, the limit is $19,500 — this isn’t the case for annuities. There are no limits on the contributions you can make to annuities in a given year.

The risks of annuities

The risks and drawbacks of annuities may outweigh their benefits, depending on your situation. The biggest disadvantages of annuities may include:

  • Hefty fees: In addition to the already steep annuity fees, there are the potential costs of riders. Riders can let you customize your annuity even further and provide different benefits, like the ability to have your payouts inherited to an heir after your death and ones that provide you with cost-of-living adjustments. These riders, though, do come at a cost, and can really add up.
  • No protection from inflation: Fixed annuities do not hedge against inflation. While the price of goods and services goes up over time, your annuity payments stay the same. This is a major drawback of fixed annuities, one you need to weigh against the promise of guaranteed income throughout retirement.
  • Potential lack of safety: While annuities are regulated at the state level through the insurance commissioner’s office, if your insurer goes bankrupt, you could be out of luck, as your annuity is not a deposit and therefore is not FDIC-insured.

Should you roll over your 401(k) to an annuity?

When considering whether you should roll over your 401(k) balance into an annuity, be sure to discuss the pros and cons with a financial planner.

According to Malcolm Ethridge, a certified financial planner at CIC Wealth in Rockville, Md., a partial rollover might be a good solution, depending on the individual’s financial circumstances, but he doesn’t advise rolling over your entire 401(k) balance into an annuity.

“Annuities in general are extremely illiquid and oftentimes come with steep penalties for accessing the funds in them within the first seven years of purchase,” said Ethridge. “They also come with higher fees than simply investing in the same ETFs or mutual funds without using the annuity to do it. The higher fees are associated with the cost of the guarantees embedded within the annuity contract.”

For instance, Ethridge warned that an income guarantee or a death benefit that returns your original principal to your beneficiaries could cost you anywhere from 0.10% up to 2.0% in fees. “But if you’re a person who needs that income guarantee to sleep at night, the added fees could be a reasonable trade-off,” he said.

Chelsea Nalley, a wealth advisor at TrueWealth Management in Atlanta, also warned of the high fees that come with annuities. But according to Nalley, for some savers the peace-of-mind that comes with longevity insurance can be worth it.

“For those that have trouble sticking to a strict budget or are nervous about the ups and downs of investing in the stock market, moving a portion of retirement assets into an annuity can provide the same structured income that the individual was used to during their working years,” Nalley said.

Nalley warns that expenses such as commissions, underwriting fees, surrender charges and fund management fees can drastically erode returns depending on which carrier you select and what additional riders are added to the annuity contract.

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