Annuity vs 401(k)Differences You Need to Know Between the Two!
People work towards a comfortable retirement.
With the many retirement funds available for people, the question of which one to go ahead with is one of the most important decisions to make.
The two most popular retirement accounts are the 401(k) and Annuities.
However, when to choose one over the other requires choices to be weighed carefully depending on different factors.
Annuity vs. 401(k)
A 401(K) is an employer-offered retirement savings plan that is named after the section of the US Internal Revenue Code (IRC).
Only employees whose employers offer 401(k) plans can make contributions towards it.
401(k) is a tax-deferred plan where an employee agrees to allow the employer to cut a certain percentage from the salary and contribute it towards the retirement plan.
At the option of the employee, the fund can be invested in different investment options, but usually towards mutual funds.
Upon retirement, a person can withdraw the funds contributed to the 401(k), and only then will the taxes be deducted.
Annuities, on the other hand, are generally sold by insurance companies and work as an investment.
Upon signing an agreement with the insurance company, the premium amount of annuities will be paid by a lump-sum amount or regular payments.
The insurance company, in return, will pay the person monthly payments from the time of retirement until death.
Major Differences Between Annuities and 401(k)s
It must be noted that not every employee can contribute to the 401(k).
An employer must have a 401(k) plan for their employees in place so that employees can start contributing to their retirement savings plan.
However, if the employer does not offer it, the employee can choose to set up his or her own 401(k) as self-employed.
The fees related to 401(k) are easy to understand.
An employee can simply ask the plan administrator to explain the fees charged against the 401(k) account.
On the contrary, annuities will charge higher fees because of commissions charged, benefit rider fees, and other fees.
When a person makes a fund withdrawal against the 401(k) before they turn 60, a 10% early withdrawal fee plus the income tax due will be charged against the amount withdrawn.
Annuities will also charge early withdrawal fees and surrender fees, which reduce over time.
Annuities do not provide a person an option of borrowing from the fund.
On the other hand, a 401(k) fund allows employees to borrow an amount from the fund.
In the event of a person’s untimely death, the 401(k) can pass on to the beneficiary while annuity benefits cease when a person dies unless there is a death benefit attached to the plan and the beneficiary of the plan holder will receive benefits like that of a regular life insurance policy.
Making Withdrawals From Annuities and 401(k)s
One of the biggest differences between annuities and 401(k) is the amount that a person receives.
Annuities pay a person regular monthly payments for as long as the person lives while the amount of pension received from a 401(k) will depend on the total contribution made against the retirement savings plan.
The 401(k) is subject to market cycles while annuities are not – meaning that even if the market goes down, the annuity payments will still be received.
But when the market is doing good, it could also mean that a higher pension will be received.
In terms of contributions, the 401(k) is limited to an amount of $20,500 with a catch-up contribution of $6,500 while annuities do not have a contribution limit and a person can choose to buy insurance worth millions.
When Should You Choose an Annuity or a 401(k)?
Given all the advantages and disadvantages of a 401(k) and annuity, people are now better suited to choose which plans work best for them.
The fact is that both these plans offer tax deferment and an effective long-term saving option for retirement that includes passing down the benefits to chosen beneficiaries.
For some people, they combine the 401(k) with an annuity in order to maximize their retirement income.
However, it would be advisable if the help of a financial advisor is sought to balance the risks and benefits against each of the retirement plans.
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Center for Retirement Research at Boston College "HOW CAN WE REALIZE THE VALUE THAT ANNUITIES OFFER IN A 401(K) WORLD?" White paper. April 12, 2022