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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The differences between annuities and 401(k) plans start to emerge when you look at their overall structure, withdrawal rules and fees.
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 annuities:
|Type||Interest Rate||Level of Risk||Annual Rate of Return|
|Fixed Annuity||Guaranteed||Low, similar to a CD||Typically 3% to 5%|
|Variable Annuity||Dependent on the investment portfolio selected||Higher, similar to a 401(k) or IRA||Based on your investments|
|Indexed Annuity||Dependent on the investment index selected, but usually has a guaranteed minimum||Medium||Based on your investments, but has limits to your potential losses and gains|
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:
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:
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:
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:
Meanwhile, with annuities, tax treatment highlights include:
While many financial advisors warn of the potential pitfalls of annuities, they do offer key advantages:
The risks and drawbacks of annuities may outweigh their benefits, depending on your situation. The biggest disadvantages of annuities may include:
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 2.00% 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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