LAST REVIEWED Dec 13 2019 8 MIN READ
When it comes to an annuity versus a 401(k), anyone can purchase an annuity, but only someone whose employer offers a 401(k) can contribute to one. A 401(k) plan is an employer-sponsored “defined contribution” retirement plan. This means that you put in a specified amount at regular intervals. An annuity is a contract you have with an insurance company that agrees to pay out a certain amount of income for a set period of time, usually for the rest of your life.
How Annuities Work
You purchase an annuity from a life insurance company. The insurance company will pool your money together with that of other investors and will pay out to those who are eligible and alive to receive the payouts. Any contributions that were made by someone who has passed away earlier than expected contribute to the gains for the overall pool.
There are a wide variety of annuities available. Some of the more common types include:
Fixed-rate annuity: With a fixed-rate annuity, you will receive a payout that is predetermined and is a contractually guaranteed amount every year. This allows you to have a predictable amount of income in your retirement years. There is a downside with fixed-rate annuities though — they don’t provide any cushion for inflation. If you receive $3,000 a month now, it might be great, but what about 15 years from now?
Variable-rate annuity: Income with a variable-rate annuity will vary depending on how premium payments were invested. The annuity company might invest in the stock market or mutual funds. These change in value and the trade-off is the certainty versus a possible higher return.
Immediate versus deferred annuity: With an immediate versus deferred annuity, you can purchase an immediate annuity now when you make a one-time payment in a lump sum. You’ll start receiving income almost immediately. With a deferred annuity, you will contribute to it now, but you have to wait a long time before receiving any income. You could be waiting for years, even decades in some cases.
Life annuity: A life annuity will make payouts until you pass away. Once you die, the payments cease. Your payments will depend on your contributions and expected life span. If you start receiving income when you are young, you can expect to receive smaller payments.
Death annuity: A death annuity will also have a death benefit for your heirs, much like a life insurance policy. Your heirs will then have a guarantee that they will receive a portion of the remaining payouts after your death.
Comparing Annuities With a 401(k)
Deciding on how to save for your retirement can be difficult. There are so many options to choose from, with 401(k) and annuities being two of the most common choices. While they share some similarities, there are notable differences, including the times you can utilize them most efficiently.
A 401(k) retirement plan is tax-deferred in that you typically sign up for it through work and fund it through regular contributions. These contributions are typically taken as deductions from your regular paychecks. Taxes on a 401(k) are not paid when you contribute to the plan. There is an exception to this rule though, and that is with a Roth 401(k), which is funded with after-tax contributions.
You can choose how you want to invest the money in your 401(k), like through exchange-traded funds, mutual funds, etc. Once you are ready to retire, you can start withdrawing funds. Once you withdraw it, you will be required to pay taxes. With the Roth 401(k), you would not pay taxes upon withdrawal since the money was accumulated using after-tax contributions.
When you purchase an annuity, you can think of it as an insurance policy that doubles as an investment. You make a single payment or multiple premium payments to the insurance company. In exchange, the insurance company will fulfill its end of the contract by paying you a certain amount at regular intervals. It’s mostly funded with after-tax money, although you can use pre-tax money in a 401(k). Annuities are great retirement planning tools because you can still invest in one after you max out your 401(k) contributions for the year.
Your annuity earnings will become taxable when they are withdrawn. The initial funds you used to purchase the annuity are usually not taxed because you already paid taxes on them, like with a Roth contribution. There is an exception, however. This is when you purchase an annuity with pre-tax money, which means your original contribution would be taxed upon withdrawal.
If you work for an employer who doesn’t offer a 401(k), then you cannot contribute to one. If you are self-employed, you can decide to set up your own. You will want to check the fees you are paying, which is quite simple. The easiest way is to ask your plan administrator to provide a breakdown of any fees that are being charged on your 401(k). Trying to figure out annuity fees can be a challenge. They also tend to be much higher than with a 401(k).
When you decide to withdraw money from your 401(k) before you turn 59 1/2 years old, you could be hit with a 10% early withdrawal penalty on top of the income tax due on the amount withdrawn. Be advised that annuities also have early withdrawal fees and something called surrender fees. Surrender fees are reduced as time passes, which means they might disappear in five years.
Inheritance is another area where 401(k) and annuities differ. Annuity payments typically end when you die, whereas people can inherit your 401(k). The exception is when you purchase an annuity that has a death benefit. Request Edit
Get Started With a 401(k) Plan
Are you a small- to medium-sized business looking to start a 401(k) plan for your company? Or do you have questions on annuities and 401(k) plans? At Human Interest, we can help. Contact us today and learn how we can help your business get a 401(k) plan in place or answer all your questions on making the most of your retirement plan.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.