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Annuity vs 401(k): What’s the difference?

Both 401(k)s and annuities are designed to help you prepare for retirement. This article will help you understand how they are different and when it may make sense to invest in both.

When it comes to thinking about retirement, you may feel overwhelmed as you consider the best way to set money aside to achieve your financial goals. 401(k)s and annuities are common financial instruments that can help you work toward the retirement of your dreams. In this article, we’ll explain how they work, the differences between the two and common benefits of each so that you can make more informed decisions.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan designed to help employees save money toward retirement. Participation in a 401(k) is voluntary, so employees of the company must enroll and decide how much money out of their paycheck will be diverted to their 401(k) plan, up to specified limits. Often, employers will choose to match a certain portion of the employee’s contributions to their 401(k). For example, an employer may match 50% of an employee’s total 401(k) contributions up to 6%. Therefore, if the employee earning $50,000 contributed 6% of their income ($3,000) to their 401(K), the employer would contribute an additional $1,500.

It's also important to note that, in most cases, a 401(k) consists of pre-tax contributions, meaning that they are deducted from your paycheck before taxes. However, when you begin making withdrawals from your 401(k) at age 59½, the money will be taxed at your effective rate at that time. You will not pay taxes on gains made through the growth of your account until you take withdrawals, making it a tax-deferred growth plan.

In terms of your investment options for the money you set aside in a 401(k), each plan comes with a defined set of investment options from which you can choose based on the level of risk you are willing to take. Some common investment options may include stock funds, bond funds, index funds and money market funds.

401(k) plans offer several advantages including the ability to set aside a portion of your income easily and consistently. Since contributions are deducted from your paycheck, you can rest assured that you are taking steps to save for retirement without having to think about it once you’ve enrolled in the program. Unlike some other programs, 401(k)s allow you to have a say in how your money is invested for retirement. Also, in cases where the employer offers a matching contribution, you can benefit from additional savings going into your retirement that don’t even come out of your paycheck.

There are, however, some drawbacks to 401(k)s. First of all, the amount of money you can contribute to a 401(k) is limited to $23,500 in 2025. For individuals aged 50 – 59, you can contribute up to $30,000 and for those aged 60 – 64, the IRS had added additional catch-up allowances of up to $11,250.¹ Another disadvantage is that you are required to take distributions from your 401(k) at age 59½.

What is an annuity?

Annuities are financial products offered by insurance companies that are designed to provide a stream of income during retirement. You contribute to an annuity through either regularly scheduled payments or a single, lump sum payment. Then, the insurance company agrees to make payments to you in the distribution phase.

There are a few different types of annuities:

Fixed annuities — A fixed annuity provides a guaranteed rate of interest over a specified period of time.
Variable annuities — A variable annuity provides the contract owner different investment options, which may offer a higher rate of return, but payments are subject to market risk.
Indexed annuities — With an indexed annuity, your money’s interest payment is tied to the performance of a market index, like the S&P 500. There may be caps placed on gains and losses.

There are many factors to consider when evaluating if an annuity is right for you. On the plus-side, annuities offer a guaranteed stream of income during retirement, which may offer peace of mind and the ability to better plan your finances for retirement. Another benefit of annuities is that they offer tax-deferred growth, meaning that you won’t pay taxes on gains until you begin receiving payments during retirement. Given the different kinds of annuities, there is potential to choose a type of annuity that has the potential to earn greater returns but, as with any investment, there is risk.

Annuities are complex financial instruments and there are fees associated with them. While fixed annuities offer a guaranteed payout, they may offer a lower return than some other types of investments. Variable annuities offer some growth potential but are associated with greater risk than fixed annuities. Most annuities come with surrender fees or penalty fees that must be paid if you withdraw from your annuity prior to the contract-defined surrender period.

What do 401(k)s and annuities have in common?

The purpose of annuities and 401(k)s are the same: to help you prepare for retirement. Both financial instruments allow you to set money aside and grow it, tax-deferred, yielding a payout at a later date. Both a 401(k) and an annuity impose penalties if money is withdrawn early.

What are the differences between 401(k)s and annuities?

While the purpose of these two financial instruments may be the same, there are many differences between the two.

Ownership and structure

An annuity involves a contract between an individual and an insurance company. A 401(k) is an employer-sponsored program for employees of a company and requires enrollment.

Tax treatment

Whereas annuities are typically funded with after-tax dollars, 401(k)s allow for the investment of pre-tax dollars, lowering your taxable income in the year(s) you make contributions. While distributions from both plans are taxed as ordinary income, the principal of an annuity is not taxed, as it was funded with after-tax dollars.

Contribution limits

Whereas 401(k) contribution limits are set by the IRS and are typically adjusted annually for inflation, annuities have no contribution limits.

Investment control and options

A 401(k) plan generally offers the most flexibility when it comes to investment options. These plans are designed to allow you to choose an option that best fits your long-term investment strategy for retirement. Variable annuities offer a limited number of investment options, giving you some level of control. Fixed annuities provide a guaranteed rate of interest, but the underlying investments are controlled by the company issuing the contract. In general, the 401(k) offers the most flexibility if you want to decide how your money is invested. Annuities are focused on providing a guaranteed stream of income and, as a result, offer less risk, but also less flexibility.

Income guarantees

Annuities offer a guaranteed income stream upon reaching the distribution phase. A 401(k) does not offer guarantees. The amount you can withdraw throughout your retirement depends on your contributions, matches and the performance of the investments selected.

Fees and charges

Annuities tend to have more complex fee structures than 401(k)s. Typically, 401(k)s may charge administrative and investment fees, but in many cases, these fees are paid by the plan sponsor. Annuities are generally subject to much higher, more complex fees designed to compensate the life insurance company for the risk associated with providing a guaranteed income stream. It’s important to check the provisions of your annuity contract for details, but some common fees associated with annuities include administrative fees, commissions, surrender charges, rate spread fees and mortality and expense fees.

Distribution rules

Distributions from retirement savings in a 401(k) fall under rules established by the IRS. Generally speaking, you need to be 59½ or older to take distributions from your 401(k) with required minimum distributions (RMDs) starting at age 73, or 75 for those born in 1960 or later.² There are some exceptions, but generally if you withdraw funds from your 401(k) prior to reaching the age of 59½, you will be subject to penalties.

Annuity payments are generally intended for retirement. Qualified annuities often have required minimum distributions at age 73, but check the provisions of your contract for details. The IRS generally imposes a 10% penalty tax on withdrawals from an annuity prior to age 59½. The insurance company may also charge surrender fees for early withdrawals.

Can you roll a 401(k) into an annuity?

If you have a 401(k) and decide to leave the sponsoring company, it is possible to roll over your 401(k) into an annuity. In a direct rollover, which is preferable in order to maintain the deferred tax status of your 401(k), your current 401(k) provider sends the funds directly to the insurance company that sells the annuity.

Alternatively, an indirect rollover involves taking a withdrawal from your 401(k) and then depositing the funds into an annuity within 60 days. This method requires you to deposit the full amount, including any withheld taxes, to avoid penalties and maintain the tax-deferred status of your retirement savings. By understanding these methods, you can effectively convert your 401(k) funds into a reliable source of retirement income. You may choose this option if you want to secure a guaranteed income stream for your retirement. If you’re worried about outliving your savings, this may be a good option for you. An annuity, specifically a fixed annuity, may protect you from market volatility. Rolling over a 401(k) into an annuity can also continue tax deferral on your money, taxing it only once distributions are made.

How to roll over a 401(k) into an annuity

To initiate a rollover of your 401(k) into an annuity, contact your 401(k) plan administrator to request a direct rollover where the funds are sent directly to the institution holding your annuity. You will be provided with forms to complete to authorize the transfer. Once the funds are transferred, the insurance company will issue your annuity contract (if it’s a new annuity) or a confirmation of funds received. It’s important to complete the rollover within 60 days to avoid early withdrawal penalties on your 401(k).

Before deciding if you will roll over your 401(k) into an annuity, it’s important to consider how much you prioritize investment growth and liquidity versus guaranteed income.

Can you have both an annuity and a 401(k)?

Yes, you can invest in both an annuity and 401(k). These and other financial tools can work together to create a strong retirement strategy. Whereas contributions to 401(k)s are limited, they are unlimited for annuities. As a result, if you have funds greater than the maximum allowable annual 401(k) contribution limit, you may also choose to invest in an annuity. The 401(k) may be a growth-oriented investment whereas investment in a fixed annuity or a variable annuity with a living benefit rider may be a good way to secure lifetime income. Together, a 401(k) and annuity can work together to balance growth potential and income security.

As an example, Mary has $500,000 saved in her 401(k) and will turn 65 next spring. She will earn $3,000/month in Social Security but believes her expenses will run closer to $4,000/month. She takes $150,000 from her 401(k) to invest in a fixed annuity, which will provide $800/month for the remainder of her lifetime. This helps bridge the income gap and she continues to let the remaining balance in her 401(k) grow.

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

Some 401(k) plans may offer an annuity as an option in the plan. If not, you can roll over your 401(k) into an IRA and then use funds to purchase an annuity from an insurance company. Speak with a qualified financial professional to ensure you evaluate your options and make the investment without tax consequences.

Factors to consider when choosing between an annuity and a 401(k)

When choosing between investing in an annuity and 401(k), here are some factors to consider.

Risk tolerance

With both 401(k) and variable annuities, the value of your contributions can fluctuate over time based on market performance. If you are extremely risk averse, a fixed annuity, which guarantees a specific rate of return, may be a good option to consider.

Retirement goals

It’s a good idea to start building your retirement strategy early to help ensure you can retire in the way and timeframe you desire. As you set aside savings for retirement in a 401(k), IRA, annuity or other financial vehicle, consider your desired retirement age, your income needs and lifestyle expectations. With these considerations in mind, you can choose the tools that will best help you achieve your retirement goals.

Other income sources

When investing in an annuity, a 401(k) or both, it’s important to consider your overall retirement goals and the other financial vehicles and savings you have in place. Start with a budget of how much you need to retire and what you think your monthly expenses will be. Then think about income sources like Social Security, if you have a pension or other income sources to understand the gap between income and expenses. An annuity may be one option for bridging that income gap.

Fees and expenses

Annuities are typically associated with higher fee structures than 401(k)s so it’s important to compare costs. Consider expenses like administration fees, investment fees, early withdrawal penalties and the costs of purchasing riders on annuities to fully compare expenses and how much they will reduce your overall contribution and growth.

Conclusion

Annuities and 401(k)s are both important financial tools that can help you achieve your retirement goals. Each has its own strengths and trade-offs, so it’s important to consider them within the context of your overall retirement strategy. It may be helpful to speak with a qualified financial professional to determine which option, or which combination of both, may be the best fit for you.

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All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and is meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective or its subsidiaries.

Learning Center articles may describe services and financial products not offered by Protective or its subsidiaries. Descriptions of financial products contained in Learning Center articles are not intended to represent those offered by Protective or its subsidiaries.

Neither Protective nor its representatives offer legal or tax advice. We encourage you to consult with your financial adviser and legal or tax adviser regarding your individual situations before making investment, social security, retirement planning, and tax-related decisions. For information about Protective and its products and services, visit www.protective.com.

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Annuity vs 401(k): What’s the difference?

What is a 401(k)?

What is an annuity?

What do 401(k)s and annuities have in common?