Planning for a comfortable retirement is a journey full of important decisions. You want to have a steady income to support your lifestyle and goals once you’ve left the workforce. So, you might consider two popular options: annuities and 401(k)s.
Both of these financial tools offer unique ways to save and generate income during retirement. However, understanding their key distinctions is essential to choosing the right option for your needs. Here’s what to know about the differences between an annuity vs. 401(k).
What Is an Annuity?
An annuity is a contract between you and an insurance company. After choosing an annuity that suits your financial goals, you contribute a one-time lump sum or payments over a set period. This is known as the accumulation phase, where your money can grow with the benefit of tax-deferred earnings.
Once the accumulation phase ends, the annuitization phase begins. This is when the insurance company starts sending you regular payments. These payments can be for a set period or the rest of your life, providing a guaranteed monthly income in retirement.
Types of Annuities
There are a few types of annuities. The right one for you depends on your risk tolerance.
Fixed Annuities
Fixed annuities offer a guaranteed rate of return and lower risk, ensuring your payments stay consistent.
Variable Annuities
Variable annuities allow you to invest in subaccounts, offering the potential for higher returns but also higher risk.
Indexed Annuities
Indexed annuities balance growth and stability, providing potential growth but protection from market downturns. Returns are linked to a market index, like the S&P 500.
Pros and Cons of Annuities
Annuities can be valuable for some, but it’s important to understand the potential downsides.
Pros
Guaranteed Lifetime Income
Annuities provide guaranteed income, ensuring you don’t outlive your savings.
Tax-Deferred Growth
Earnings in an annuity grow tax deferred, so your money can compound over time.
Potential for Higher Returns
Certain annuities may offer higher returns than others, though they come with more risk.
Protection from Market Downturns
Fixed annuities provide stability and can help protect your savings from volatility.
Cons
Limited Liquidity
Accessing your funds before the annuity matures may involve fees or surrender charges.
High Fees
Annuities can come with fees, which can impact your overall returns.
Complex Terms and Conditions
Annuity contracts can be detailed. Carefully review all terms before committing.
Limited Control
Depending on the annuity, you may have limited control over investment choices or the timing of withdrawals.
What Is a 401(k)?
Many employers offer a 401(k) retirement savings plan but not all employers offer this benefit. A 401(k) enables workers to save for future retirement needs and has tax advantages. If your employer offers a plan and you’ve earned an income, you can contribute a percentage of each paycheck directly to it. Some employers even match a percentage of contributions, giving you free money to boost your savings.
Types of 401(k)s
401(k) plans fall into two categories.
Traditional 401(k)
Any contributions to a traditional 401(k) are pretax, which reduces your taxable income for the year. Investments grow tax deferred, so you don’t have to pay taxes on earnings until you withdraw funds in retirement.
Roth 401(k)
Your contributions to a Roth 401(k) are with after-tax dollars, so you don’t get an upfront tax deduction. However, investments grow tax-free, and qualified withdrawals in retirement are tax-free, too.
Pros and Cons of 401(k)s
401(k)s offer advantages for retirement savings but also have potential drawbacks.
Pros
Tax Benefits
401(k)s offer tax advantages, either through tax-deferred growth (traditional) or tax-free withdrawals (Roth).
Employer Match
Many employers offer a matching contribution, free money to boost your savings.
High Contribution Limits
401(k)s have higher annual contribution limits than individual retirement accounts. In 2024, the limits are $23,000, with a $7,500 catch-up contribution if you’re over 50.
Automatic Payroll Deductions
You contribute to the account directly from your paycheck, making saving automatic.
Cons
Limited Investment Options
Your investment choices may be restricted to a preselected list of funds within the plan.
Potential Fees
401(k) plans may have administrative and investment fees that can affect your returns.
Early Withdrawal Penalties
If you need to access your 401(k) funds before you’re 59½, you may face a 10% early withdrawal penalty. Plus, you’ll owe income taxes on the withdrawn amount.
Required Minimum Distributions (RMDs)
Once you’re a certain age (currently 73), you must begin taking annual RMDs. RMDs are treated as taxable income, which could have tax implications.
Comparing Annuities and 401(k)s
Here’s a closer look at annuities vs. 401(k)s to help you understand the differences.
Income
- Once in the annuitization period, an annuity can provide a guaranteed income stream.
- Your 401(k) income depends on how much you’ve saved, your investment performance, and your withdrawal strategy.
Taxes
- A portion of each annuity payment is typically considered taxable income. Funds also grow tax deferred.
- Traditional 401(k)s provide tax-deferred growth, while Roth 401(k)s offer tax-free growth and withdrawals.
Liquidity
- Annuities generally have limited liquidity; withdrawing your funds early may involve fees.
- While withdrawing from your 401(k) before 59½ comes with penalties, you have more flexibility to access funds.
Investment Options
- Depending on the annuity, your investment options may be limited.
- Generally, you’ll have more investment options with a 401(k), giving you more control over your investment strategy.
When to Choose an Annuity vs. 401(k)
There’s no one right answer for saving for retirement; what works for you depends on your goals, risk tolerance, and retirement needs. However, one may stand out as a good fit for you in a few circumstances.
You May Consider an Annuity If:
- You prefer having a predictable monthly income throughout retirement.
- You’re uncomfortable with the market’s ups and downs and prefer a different approach.
- You’re nearing retirement age and want to ensure you don’t outlive your savings.
You May Consider a 401(k) If:
- You want more control and flexibility over your investments.
- You have a higher risk tolerance and are okay with market fluctuations in exchange for higher potential returns.
- You have a longer time horizon until retirement and want to focus on long-term growth and the benefits of compounding interest.
Moving Forward with the Right Option for You
As you explore your options, remember finding the right choice for you depends on your financial situation, savings plan, and long-term retirement goals. Annuities and 401(k)s offer distinct advantages and disadvantages, and speaking with a financial professional can help you evaluate your options and create a personalized retirement plan.
Contact a Bankers Life representative to discuss potential sources of retirement income and how each suits your needs.
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Bankers Life Securities, Inc., Bankers Life Advisory Services, Inc., and their representatives do not provide legal or tax advice. Each individual should seek specific advice from their own tax or legal advisors.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Bankers Life is the marketing brand of various affiliated companies of CNO Financial Group including, Bankers Life and Casualty Company, Bankers Life Securities, Inc., and Bankers Life Advisory Services, Inc. Non-affiliated insurance products are offered through Bankers Life Securities General Agency, Inc., (dba BL General Insurance Agency, Inc., AK, AL, CA, NV, PA).
Securities and variable annuities offered through Bankers Life Securities, Inc. Member, FINRA/SIPC (dba BL Securities Inc., AL, GA, IA, IL, MI, NV, PA). Advisory products and services offered by Bankers Life Advisory Services, Inc. SEC Registered Investment Adviser (dba BL Advisory Services, Inc., AL, GA, IA, MT, NV, PA).
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Investments are: Not Guaranteed—Involve Risk—May Lose Value.
