Annuity vs 401(k) -- Similarities and Differences

How are you going to afford your retirement? This is one of the most important personal finance decisions you’ll make.

Plan well, and you’ll live the rest of your life feeling financially secure. Plan poorly, and you could end up feeling worried and insecure.

Fortunately, there are lots of retirement savings options available. And the government provides several tax advantages to help incentivize saving for retirement.

The only downside is that there’s a lot to know.

In this article, we explain the differences between annuities and 401(k)s—two of the most common and important retirement planning instruments.

We explain what each is, how they’re similar, how they’re different, and how to decide which is best for you.

What Is an Annuity?

An annuity is a contract you make with an insurance company. You agree to pay the company a premium (a deposit of funds) in exchange for guaranteed retirement income. There are several types of annuities, each with its own flavor and characteristics.

The following is a brief overview of the different annuity types.

Immediate vs. deferred annuities: With an immediate annuity product, you pay your premium to the insurance company, and you begin to receive your income payments soon after. On the other hand, a deferred annuity allows your premium time to accumulate interest earnings and grow. And when (or if) you decide to turn the deferred annuity into a flow of income via annuitization or take a lump sum payment in retirement, your account value will have grown on a tax-deferred basis.

Single vs. flexible premium annuities: In a single premium annuity, you pay the premium in a single lump sum. In a flexible premium annuity, you pay the premium with regular payments over time.

Fixed, variable, and fixed index annuities:

• With a fixed annuity, your annuity interest rate has a fixed minimum. The rate will not drop below that minimum over your annuity contract term.
• With variable annuities, the interest rate your annuity earns depends on stock market performance. You choose sub-accounts to invest your premium in, and the performance of these sub-accounts determines your return. As a result, your effective interest rate can be high or low—you might even lose money if your investment choices perform poorly.
• Fixed indexed annuities combine different aspects of fixed annuities and variable annuities. They use the performance of a market index (like the S&P 500) to determine how much interest you will be credited. There is also usually a fixed minimum to ensure you don’t lose money if the market does poorly.

Though these annuities may differ in their details, they all have one thing in common:

They can provide guaranteed income in retirement.

What Is a 401(k)?

A 401(k) is an employer-sponsored retirement plan. You direct your employer to deduct a portion of your salary and put it into a retirement savings plan. If you’re lucky, your employer may even match your contributions.

The money in this account is then invested in a portfolio of assets that you choose. These could be mutual funds, exchange-traded funds (ETFs), or other assets.

Any money earned from the investments is reinvested in your account. If you choose your investments well, your account grows over time with earnings.

You can begin to withdraw the funds once you reach retirement.

Traditional and Roth 401(k)s

Traditional 401(k)s are tax-advantaged in a number of ways.

First, contributions are taken out of your salary before they’re taxed, reducing your taxable income.

Second, you only pay taxes when you withdraw money from the account.

Since you usually withdraw money from your 401(k) in retirement when your income is lower, most people end up paying less in taxes overall.

Also, since your earnings are not taxed right away, they stay in your account and help it grow faster.

Some employers offer Roth 401(k)s. Roth 401(k)s are similar to traditional 401(k)s, except your contributions are made with after-tax money.

So, when you withdraw your money in retirement, you won’t have to pay taxes on the contributions (although you will still pay taxes on earnings).

Note that because there are significant tax advantages, there are limits on how much you can contribute to a 401(k).

For 2020 and 2021, the annual limit is $19,500. After that, you can contribute an extra $6,500 if you’re over age 50.

Annuities vs 401(k)s: What Are the Similarities and Differences?

Now that we’ve laid out what annuities and 401(k)s are, we can discuss their similarities and differences.

Accessibility

401(k)s: These retirement plans are only available if your employer offers them (you can also open for yourself if you’re self-employed). But if your employer doesn't offer them, you’re out of luck.

Annuities: Annuities are available to anyone and everyone. You can even buy annuities online.

Contribution Limits

401(k)s: The Internal Revenue Service (IRS) puts annual limits on the amount you can contribute to a 401(k).

Annuities: Usually, annuities don’t have contribution limits. You can contribute as much as you like, although some insurers may restrict your premium amount.

Role of Your Employer

401(k)s: Employers drive 401(k)s. Employers decide who is eligible, whether they match, and how much they contribute.

Annuities: Annuities are not tied to your employer. They are an agreement between you and your insurance company.

Earnings

401(k)s: The earnings on your 401(k) account will depend on the performance of the portfolio of assets that you choose to invest in. If those assets appreciate, you earn money. But if they depreciate, you can lose money, too.

Annuities: Earnings on your annuities depend on what type of annuity you purchase. Both variable and fixed indexed annuities use market performance to calculate your rate of return. But fixed annuities give you a guaranteed minimum interest rate over the term you select, regardless of how the market is doing. Fixed annuities are one of the safest investment options around because you’re guaranteed not to lose money.

Fees

401(k)s: Like most investment accounts, 401(k)s typically have management fees attached to them. These fees can range from 0.2% to 5% of your contribution.

Annuities: Insurance companies vary widely in terms of the annuity fees they levy. Most charge a fee for variable annuities. Some also charge a fee for fixed annuities. Many charge fees for death benefits or other riders. Additionally, virtually all insurance companies pay their agents a commission fee, although they usually build this cost into the policy.

At Canvas, we do things differently. Our agents are not commission-based, and we don’t have account charges or fees on our annuities.

Early Withdrawal Penalties

Both annuities and 401(k)s are meant to help you save for retirement. If you take money out early, you’ll usually have to pay a penalty.

401(k)s: The IRS levies a 10% penalty on early withdrawals from individual retirement accounts (IRAs)—including from 401(k)s—if you withdraw your funds before you turn 59½.

Annuities: Withdrawals from annuities before you turn 59½ face the same IRS penalty that 401(k)s face.

In addition, the insurance company may charge you a surrender charge if you withdraw money before your surrender charge period ends. (The surrender charge period and surrender charge amounts are listed in your annuity contract.)

Withdrawals and Payouts

401(k)s: Once you reach 59½, you can withdraw from your 401(k) account without penalty. You can withdraw money in a single lump sum or in smaller disbursements—it just depends on your preferences. Required minimum distributions begin once you reach age 72.

Annuities: You can begin to withdraw from your annuity penalty-free once your surrender period is over and you reach age 59½. Like a 401(k), you can withdraw from your annuity in a single lump-sum payout, although most people choose to annuitize the annuity and receive periodic annuity payments. Depending on the payout scheme you chose, guaranteed payments may last you the rest of your life.

Taxation

Both annuities and 401(k)s provide tax advantages, including tax deferral. That means you pay taxes later when you withdraw funds from the account.

401(k)s: 401(k) contributions are deducted directly from your salary, so you don’t pay taxes on them right away. Instead, you pay ordinary income tax on the distributions from your 401(k) when you receive the money in retirement.

Annuities: You pay ordinary income tax on annuity payouts. The amount you pay in taxes depends on whether you have a qualified or a non-qualified annuity—i.e., whether you funded your annuity with pre-tax dollars or after-tax dollars.

If you already paid taxes on your premium, you'll only owe taxes on the earnings. But if you purchased your annuity with pre-tax money, you'll owe taxes on your entire withdrawal. Note that neither 401(k)s nor annuities are tax-free.

401(k)s vs. Annuities—Which Is Right for You?

Deciding between an annuity and 401(k) plan and unsure which is the better option for you?

Here are some tips for deciding.

A 401(k) may be appropriate for you if:

• Your employer offers one
• You’re confident about choosing how to invest your money
• You have a higher risk-tolerance and are okay with potentially losing money

A fixed annuity may be a better choice for you if:

• Your employer doesn’t offer a 401(k)
• You want guaranteed income in retirement
• You want a very low-risk option
• You want a guaranteed interest rate over the term you select
• You have maxed out your contributions to your 401(k) and other retirement savings accounts

Annuities and 401(k)s Can Work Together

Remember, you might not actually have to choose between these two retirement options.

If you wish, you can rollover your 401(k) into an annuity.

You might want to do this if you change employers and your new employer doesn’t offer a 401(k) plan.

You also might want to do this once you’re close to retirement so you can reap the benefit of guaranteed growth and income.

You can also sometimes use the funds in your 401(k) to buy an annuity—but only if your 401(k) plan allows this.

Annuities can also be a great place to put that extra cash you have lying around once you’ve maxed out your 401(k) contributions.

So, is a 401(k) an annuity?

No, they’re different. But you can buy an annuity with funds from a 401(k). And you can hold your annuity within a 401(k).

If you're unsure, talk to a financial advisor for more details about using your 401(k) in conjunction with an annuity.

Is an Annuity Considered a 401(k)?

No, an annuity is not the same thing as a 401(k).

A 401(k) is a type of retirement account that acts kind of like a container for financial products. An annuity is a financial product.

Retirement Doesn’t Have To Be Stressful

Both annuities and 401(k)s are designed to make retirement planning easy. They both help you get out in front of your retirement savings and supplement your social security check.

The idea is, if you plan for retirement ahead of time, you can spend your golden years feeling financially secure and carefree.

401(k)s and annuities are both tax-advantaged, helping you supercharge your savings and maximize your growth.

But only annuity contracts can provide you with a guaranteed income stream.

If you don’t want to leave your retirement up to chance, annuities are your best bet.

Talk to our experts today to understand exactly how annuities can provide you with a lifetime income to help secure your financial future.

An annuity could be the best investment decision you make.