Many people wonder how investing in an annuity versus a 401(k) compares when it comes to saving for retirement.
Both are tax-advantaged, in that investments made through each grow tax-free until they’re withdrawn in retirement. But while an annuity is a type of insurance contract that’s an investment itself, an employer-sponsored 401(k) is a special kind of account that holds a variety of investments.
Introduction to retirement savings
Although 401(k)s often are called retirement plans, they don’t provide a stream of regular income in the way that traditional pensions or Social Security benefits do.
Annuities, on the other hand, can provide guaranteed regular income for life through a process known as annuitization. Yet, largely because many annuities — notably variable and index annuities — are sold as a tax-advantaged way to accumulate savings, about 90% of annuities are never annuitized, in which case the money continues to earn interest and/or dividends while going up or down in value depending on how it’s invested.
Pros and cons of 401(k)s
In general, 401(k) plans — and the very similar 403(b) plans offered by nonprofit organizations — are a better way to grow your cash for retirement than an annuity.
For starters, 401(k) contributions are deducted from your taxable income, while annuity purchases generally aren’t. For 2024, an employee can contribute up to $23,000 to a 401(k) plan and deduct the contribution from their taxable income.
Income taxes are deferred until the employee starts taking distributions from the account in retirement. Except when they’re purchased as a rollover within a qualified plan, such as a 401(k) or an individual retirement account (IRA), annuities are purchased with after-tax dollars, so there’s no immediate tax benefit.
Most good 401(k) plans also offer a wide variety of investments that include target-date funds, equity and fixed-income mutual funds and exchange-traded funds. The mix enables a participant to create a broadly diversified portfolio. Depending on the annuity, some also offer a range of investments while others offer just one type.
When it comes to the topic of fees and costs, it’s a minefield for 401(k) plans and annuities alike because the performance of each will suffer when fees and costs are too high. In a 401(k) plan, there are costs associated with administering the plan itself and costs associated with each of the investments offered in the plan. Sometimes, the plan sponsor (the employer) will pay the costs of administering the plan; sometimes they pass along a pro-rata share of the cost to participants. The best plans offer mutual funds that carry low management fees.
Transactional fees and commissions connected to buying and selling investments in a plan can also add to costs. According to the National Association of Plan Advisors, 401(k) plans charge fees of around 1%, depending on the size of the plan, which covers fund-specific and administrative costs.
In terms of simplicity, 401(k) plans have something of an edge. While understanding the investment choices in a plan may take some effort, most plan sponsors and investment providers offer information and guidance to help in decision-making.
In contrast, variable annuities — the type used most frequently in the years leading up to retirement — can have complex features on top of a range of investment choices.
| Pros | Cons |
|---|---|
Contributions to traditional 401(k) reduce taxable income | Employee contributions limited to $23,000 ($30,500 for those 50 and older) |
Offer a wide range of investment options | Fees and costs can reduce returns |
Investments and features are relatively simple to understand | May go through probate if no beneficiary is selected |
Employers may make matching contributions | Cannot contribute after retirement |
The role of employers in 401(k)s
Another advantage 401(k)s have over annuities is that employers may contribute to their employees’ 401(k) plans. To encourage retirement saving, many employers offering a 401(k) plan will match a portion of the employee’s contribution, making that amount essentially “bonus” income.
In 2024, the limit for combined employee and employer contributions is $69,000. In better plans, there is immediate eligibility and employer-matching. Outside of a qualified plan, annuity purchases come with no employer contribution.
Types of annuities
An annuity is a contract in which an insurance company can make regular payments to the contract holder — a feature known as annuitization — in return for a lump-sum premium payment or a series of premium payments. Insurance companies have created many types of annuities that differ by when premium payments are made and by how much, the timing of the payments, and the investments that underlie the contract.
Immediate annuities
Perhaps the least complex annuity is a single-premium immediate annuity. In return for a one-time, lump-sum premium payment, the contract holder immediately starts to receive a stream of income periodically (monthly, quarterly or on some other schedule) for the rest of his or her life. If they wish, the policyholder typically can buy a rider, or an additional feature, that extends the payments to cover the life of a surviving spouse.
Deferred annuities
In contrast to immediate annuities, deferred annuities offer the annuitization feature at some later time after what is known as the accumulation period or accumulation phase, during which the contract holder makes periodic payments to the insurance company. Deferred annuities come in many varieties, including fixed, variable and fixed-indexed annuities.
Fixed annuities
Fixed annuities pay a set amount on the investments for the term of the contract. Both the interest rate and the principal amount are guaranteed with a fixed annuity.
Variable annuities
Variable annuities, which essentially are mutual funds wrapped in an insurance contract, rise and fall in value based on the returns of the underlying funds.
Indexed annuities
More complicated are indexed annuities, in which returns are linked to the performance of a stock or bond market index and which offer ways to protect against investment losses.
Pros and cons of annuities
Annuities offer many features that make them attractive for high-net-worth individuals. Tax-deferred growth and no contribution limits are particularly appealing to those who have already maxed out other tax-advantaged savings vehicles. As an insurance product, annuities enable owners to pass assets to beneficiaries without probate because the assets aren’t considered part of one’s estate. Those insurance benefits, however, come at a cost that less-affluent investors may feel isn’t worth paying.
Annuity costs tend to be higher in total than 401(k) plan costs because they include the often high commissions paid to the securities brokers and insurance agents who sell the products, as well as the cost of the insurance component that is integral to every annuity. Depending on the features selected, a variable annuity might have expenses of 2% to 3% a year.
| Pros | Cons |
|---|---|
No contribution limits | Contributions generally do not reduce taxable income |
May offer a guaranteed rate of return | Offer relatively limited investment options |
Can provide a stream of lifetime payments | Fees and costs are generally higher than 401(k) plans |
Allow holders to pass assets to beneficiaries without probate | Complex features are not always easy to understand |
How are annuities and 401(k)s similar?
Generally, the purpose of annuities and 401(k) plans is similar: to provide income in retirement. Many annuity purchasers, however, buy annuities as an investment with no intention of ever annuitizing. As an investment vehicle, deferred annuities seem most like a 401(k) plan because they typically offer a variety of investment choices during the annuity’s accumulation phase. Like investment gains in a 401(k) plan, investment gains held within an annuity contract are not taxed during the accumulation phase. Upon withdrawal or annuitization, taxes are owed only on the annuity’s gains if the annuity was purchased with after-tax dollars.
How do annuities and 401(k)s differ?
Because most annuities offer the option of annuitization, which means receiving a life-long stream of income from the investments within the annuity contract, annuities are much more like a conventional defined benefit pension than a 401(k) plan. One of the most challenging retirement planning issues 401(k) plan holders face is determining the amount of money that can be withdrawn safely from their plan annually to provide income without the danger of running out of money. In an annuity that is annuitized, a contract owner can be assured of receiving a specified regular amount of money (or one that adjusts upward with inflation, if that feature is chosen) for the rest of their life. Many annuity contracts also permit withdrawals of lump sums.
Tax implications for annuity and 401(k)
Annuities and 401(k)s are similar in that they both offer savers an opportunity for tax-deferred growth. Contributions made by an employee and an employer to a 401(k) plan grow tax-deferred during the life of the account. Annuities also provide tax-deferred growth. Tax deferral helps the value of funds in 401(k) accounts and annuities grow more quickly than in taxable accounts.
As for withdrawals, since 401(k) plans are designed as retirement savings vehicles, the IRS imposes a 10% penalty on sums withdrawn from these accounts before age 59 1/2. Withdrawals also are subject to ordinary income tax.
You may be able to withdraw money from a 401(k) without penalty under certain circ*mstances, including if you are or become disabled, you give birth to a child or adopt a child during the year (up to $5,000 per account), or you qualify for certain hardship withdrawals such as those used for medical bills, college tuition and funeral expenses.
In an annuity — whether fixed, indexed or variable — withdrawals are permitted but are also subject to the 10% penalty if made before age 59 1/2. In addition, withdrawals are subject to surrender fees before a pre-set time period, usually three to 10 years. Surrender fees, which are designed to recoup the commissions the insurer paid to sell the product, typically start at about 7% for withdrawals in the first year of the annuity contract but wind down over time, according to the Insurance Information Institute.
Frequently asked questions (FAQs)
Yes. There are no restrictions on having both an annuity and a 401(k).
Most employers will release your 401(k) when you leave your job. You have 60 days to roll it over to a new plan. Your new employer may accept the rollover or you can roll it into an IRA. To help avoid incurring any penalties or taxes, make sure the transfer of the account is handled on a direct rollover basis from the old custodian to the new custodian, not in a check to you.
Depending on how the funds in the annuity are invested, you can lose money if the value of the investment declines. Some annuities offer riders, or extra-cost provisions that add a benefit, which can protect against principal losses. Fixed-rate guaranteed annuities pay a set interest rate, so there is no potential for loss of principal except in the unusual case of the insurance company’s failure.
In a 401(k), there is no direct way to hedge the impact of inflation. While fixed-income investments tend to underperform during periods of inflation, equities tend to keep up with inflation, and real assets like real estate and commodities tend to do better. But that’s a generalization.
Annuity performance tends to mirror that of markets generally, but many annuities also offer a cost-of-living rider at the time of annuitization. That extra-cost option gives inflation protection to those who annuitize, raising their regular monthly payments when inflation rises.
