Annuity vs 401(k): Which Is Best?

Retirement is a financial goal that many people intentionally work towards. It’s not something that happens overnight. Contrary to what some may believe, retirement savings don’t just happen, it needs to be planned, like any other financial goal.

That begs the question of how to fund your retirement. Annuities and 401(k) plans are often mentioned regarding retirement. But, if you’re just getting started, you may feel conflicted between the two. If you’re wondering which one, an annuity or a 401(k), is better for meeting your retirement goals, we can help.

What Is an Annuity?

An annuity is a tax-deferred product many people help fund their retirement. It can be purchased through an insurance company as a lump sum, or you can pay premiums over time. In most cases, annuities can provide you with monthly income for the remainder of your life. There are different types of annuities to meet the needs of specific goals.

How Are Annuities Purchased?

Annuities can be purchased in one of two ways:

1. Immediate Annuity
Immediate annuities are paid with a lump sum payment, guaranteeing you monthly income in as little as a year after it’s purchased.

2. Deferred Annuity
Deferred annuities are purchased through monthly premiums like an insurance policy, and are accumulated over a period of time. After a determined date, you can begin receiving monthly payouts of your accumulated income.

How Are Annuities Paid Out?

Annuities can be paid out in these two ways:

1. Lifetime Annuities
Annuities can be paid out for the rest of your entire life if set up to do so. The amount of the payout is determined by the purchase amount and your age.

2. Fixed-Period Annuities
Fixed-period annuities are set up to begin paying out at a specific time and will be paid out for a certain period of time. With a fixed-period annuity, your age does not impact the monthly amount of your income.

How Do Annuities Grow?

Fixed Annuities

Fixed annuities are a stable and predictable way to accumulate income through your annuities. The interest rates are always the same as what’s stipulated in the annuity contract.

Multi-Year Guaranteed Annuities (MYGAs)

MYGAs are annuities with fixed interest rates only for a specific period.

Variable Annuities

The accumulation of variable annuities depends on the stock market’s performance (stocks, bonds, and other accounts fund that particular annuity).

Fixed-Index Annuities

Payments from fixed-indexed annuities are based on the market index. The difference between fixed-indexed annuities and variable annuities is your principal investment is always protected with fixed-index annuities.

What Is a 401(k)?

A 401(k) is a retirement plan employers offer to help fund your retirement. In order for the plan to take effect, you have to contribute a percentage of your pre-tax income toward the plan. In some situations, employers will also contribute a set percentage or a match of the pre-tax income you contribute.

How Is a 401(k) Purchased?

401(k)s are not purchased. Instead, it’s a plan you can buy into by contributing to it regularly. Since employers offer 401(k)s, employees are responsible for initiating the account. That is done by allocating certain wages to be deducted from your paycheck to go into the account. You control your account and manage how conservatively you want to invest. There are two types of 401(k)s: traditional and Roth.

Traditional 401(k)

With a traditional 401(k), money grows tax-deferred, and you pay taxes on any withdrawals you make based on your tax bracket.

Roth 401(k)

With a Roth 401(k), there are no upfront tax breaks, but you get to withdraw your money without having to pay taxes on it.

How Is a 401(k) Paid Out?

You can begin withdrawing from your 401(k) account anytime after turning 59 ½ years old. If you withdraw from your account before this age, you’ll adhere to early withdrawal penalties and must pay at least 10% of what you withdrew.

How Does a 401(k) Grow?

Typically, you can choose the type of investment you want to make once you start contributing to a 401(k) account. You can choose from a selection of mutual funds that invest in stocks, bonds, or other types of investments. Funds in your account will risk growing based on how the market is performing. Depending on your investment type, you could also be at risk of losing money put into the account.

How Are Annuities and 401(k)s Similar?

Annuities and 401(k)s have a lot in common:

  • Both options allow you to save money for the long term by contributing to them over a period of time.
  • They both allow for tax-deferred growth, meaning you only pay taxes when you make a withdrawal.
  • Both require you to let your money grow for a period of time. Withdrawing before the established time causes you to pay an early withdrawal penalty.
  • Both allow you to name a beneficiary to your account so that they will have access to your funds should anything happen to you.

How Are Annuities and 401(k)s Different?

There are also some differences between the two types of savings mechanisms:

  • Annuities are purchased through an insurance company, and agents receive commissions on your purchase. Your employer receives nothing when you contribute to a 401(k).
  • Employers can match what you contribute to a 401(k), which will help your account grow even more. You are the only one contributing to the annuity.
  • There are annual limits to how much you can contribute to a 401(k). There is no limit to how much you contribute to your annuity.
  • In addition to the early withdrawal penalty, other fees may be associated with an annuity. There are no additional fees associated with a 401(k).
  • Annuities have the option of providing you with income for life. There is no guarantee that the funds in your 401(k) will outlive you, and depending on how the market performs, there’s no guarantee of the final outcome of your savings at retirement.

How To Choose Between the Two

Who says you have to choose? Planning early retirement gives you the clarity to consider all your investment options. Opting for an annuity and 401(k) combination could be an incredibly smart move. Remember, 401(k)s have a max on how much is contributed. If you reach that max, maybe an annuity is a good place to put any extra money you’d like to save.

The Bottom Line

When you start planning for retirement early, you have plenty of time to consider all your options for funding your retirement. Never think you have to be limited to only one option. Consider how much money you’d like to accumulate for retirement and then utilize the investment vehicles you think will help you reach that goal. Remember, no investment choice doesn’t come with risks, so it’s always great to have something to fall back on.

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