How To Choose Between an Annuity vs. 401(k)

Annuities and 401(k)s are both strategies for saving and accumulating retirement assets and maintaining financial security during retirement. The right choice for you depends on your financial goals, income, risk tolerance, age, and more. 

An annuity can provide a guaranteed income stream for the rest of your life, but it may not have the same upside potential (or risk) associated with investing in a 401(k) retirement account. In this article, we’ll discuss how to choose between an annuity vs. 401(k), including situations where you can take advantage of both options.

401(k) Plans and Annuities Explained

In a nutshell, an annuity is an insurance product that provides guaranteed income. With an immediate annuity, you can turn a lump-sum payment into guaranteed income payments for the rest of your life. With a deferred annuity, you can grow your account on a tax-deferred basis and receive income after a set period. You can also use a split annuity strategy to combine both options, placing some funds in an immediate annuity and the rest in a deferred annuity.

NOTE: All guarantees are subject to the claims-paying ability of the insurer.

There are three major types of annuities:

• Fixed: Your account is credited a guaranteed interest rate set by the insurance company independent of the market. 
• Fixed Indexed: With an indexed annuity, your account gains interest based on an index like the S&P 500. The insurance company guarantees a minimum interest rate and protects the principal. 
• Variable: Your premiums are invested in sub-accounts, and your account can gain or lose value based on market performance.

A 401(k) plan allows you to put a portion of your pre-tax income into an investment account. The account rises and falls based on the performance of your investment choices, and you pay taxes once you begin taking money out. You have to be 59 ½ years or older to avoid penalties for early withdrawals. You can get a traditional 401(k) if your employer offers one or use a solo 401(k) if you’re self-employed or own a business with no employees.

Annuity vs. 401(k): Similarities

Annuities and 401(k) plans have many similarities, from their main objective of retirement income generation to penalties for taking payouts early. Here are a few similarities:

• Tax advantages: Both annuities and traditional 401(k) plans provide tax-deferred growth. This means you aren’t taxed on capital gains yearly but instead pay taxes when you withdraw funds. (With a Roth 401(k), you contribute after-tax dollars and are not taxed on your withdrawals.)
• Retirement income: Building an income for retirement is a primary objective of both annuities and 401(k) plans. You can create a nest egg with a 401(k) and draw it down in retirement or purchase an annuity for a predictable income later on.
• Early withdrawal penalties: Annuities and 401(k) plans are designed for the long term. You have to wait until age 59 ½ to withdraw from a 401(k) or annuity without paying a 10% tax penalty. Annuities also have surrender charges for certain withdrawals before the accumulation phase is over or you reach a certain age.

Annuity vs. 401(k): Differences

While annuities and 401(k) plans share overarching themes, the differences between them are important to understand. Major differences include who offers and manages each product type along with their respective risk and return potentials.

Annuity Companies vs. 401(k) Providers

One of the biggest differences is in who offers these plans. Financial institutions like Merril Lynch, Vanguard, and Charles Schwab offer 401(k) plans, and many people access these plans through their employers.

On the other hand, when you buy an annuity, you sign a contract with an insurance company. The insurance provider will make payments to you in return for premiums or a lump sum to purchase the annuity.

Contribution Limits

401(k) plans limit your annual contributions while annuities don’t. Annual 401(k) contribution limits for 2024 and previous years are: 

• $23,000 in 2024
• $22,500 in 2023
• $20,500 in 2022
• $19,500 in 2021 and 2020
• $19,000 in 2019

If you’re 50 years old or older, you can also make catch-up contributions. The annual catch-up contribution limit in 2024 was $7,500.

You don’t have to worry about contribution limits with an annuity. Different types of annuities offer flexibility for when and how much you contribute.

What’s the Risk?

An advantage of an annuity is it typically carries less risk than a 401(k) plan. Fixed and indexed annuities typically guarantee minimum interest rates. This means that most annuities shouldn’t lose value. (This isn’t the case with a variable annuity, which can lose value based on market conditions and depending on contract features.)

401(k) plans, in contrast, don’t have any safeguards to keep your investment above a certain value. When the market performs poorly, a 401(k) can lose up to 100% of its value depending on the funds in its portfolio.

What’s the Return?

While 401(k) plans carry more risk, they also have a higher potential for return than most annuities, aside from variable annuities. If your investments gain 8% over time, your account gets the whole increase. You can see significant gains by investing in a 401(k) over the long term.

Annuities may have lower returns because the insurance company either guarantees an interest rate or protects your account from downturns in the market. Indexed annuities can have participation rates and/or spread fees that lower the return you see in your account. If a participation rate is 75%, your account gets 75% of the index’s gain and the insurance company gets the other 25%. Variable annuities also have fees to compensate the insurance company for taking on risk.

Fixed annuities grow at interest rates guaranteed by the insurance company, which are usually below index rates. For example, guaranteed interest rates on deferred fixed annuities through Charles Schwab range from 3.45 to 4.85% at the time of writing. These rates may start higher in the first year and decline slightly over the accumulation period.

How Long Does Your Money Last?

An annuity provides payments for a period of time or life depending on the contract, while a 401(k) lasts until you withdraw all the value or the portfolio loses value based on the market. Annuities with lifetime riders guarantee income for the rest of your life, though this guarantee may come at an additional cost. A 401(k) doesn’t provide this, and there’s a chance you could outlive your account.

How To Choose Between a Retirement Annuity vs. 401(k)

Your age and financial plan play important roles in deciding between an annuity or 401(k). If you’re an early- or mid-career professional, you have time to grow a 401(k) account. It’s also a good idea to take advantage of an employer match program if you can.

On the other hand, if you’re within a decade of retirement, a 401(k) is less effective, even if you can contribute a significant amount upfront. An annuity is a great alternative to a 401(k) in this case. You can turn your contribution into guaranteed income in a decade or less depending on the contract.

Another difference to think about is what happens after you pass away. Many annuities offer riders at an extra cost, providing you with death benefits that pay income to your dependents. This is similar to a life insurance benefit, though annuity death benefits are taxable as income, whereas insurance death benefits are usually income tax-free. With a 401(k), your beneficiaries get the assets in your account, not an agreement of payments.

Can an Annuity and 401(k) Work Together?

You don’t have to choose one or the other—an annuity and 401(k) can work together in multiple ways. Here are a few examples:

• You can roll money from a 401(k) into an annuity once you retire to get guaranteed income for life. This can often be done through a 1035 exchange, which can provide tax benefits.
• You can diversify your retirement plan by having a more aggressive investment mix in a 401(k) and a safer fixed deferred annuity.
• You can keep a 401(k) to simply take advantage of an employer’s match program and put other retirement funds in an annuity.

Speak With a Financial Advisor To Decide

Annuities are complex financial products. They have the potential to provide income for life, but choosing the right annuity products and deciding how to balance your savings between annuities, your 401(k) and other options can be difficult. To learn more about 401(k)s and to understand how a 401(k) could help you, contact a financial advisor with a securities license. To get help planning your retirement with an annuity, reach out to one of Annuity.com’s licensed agents today.