Planning for retirement involves a lot of compromise and sacrifice. That’s why it’s important to use every advantage you can when contributing to your retirement savings. The most common advantages are the tax benefits that investment vehicles offer. Two of the more popular tax-advantaged accounts are annuities and 401(k)s.
When deciding to contribute to either investment product, how do you know if one is better than the other? They both have advantages and disadvantages and choosing one will depend on your specific financial situation.
Before you determine if an annuity is better than a 401(k) you need to understand what each of these investment vehicles entails.
What is an annuity?
An annuity is a financial product that helps investors save tax-deferred dollars for retirement or to supplement their income. With an annuity, you pay a financial institution a certain amount of money, either as a lump sum or as a sequence of payments, in exchange for a guaranteed recurring payment.
Annuities are generally divided into two categories: fixed annuities and variable annuities. Fixed annuities provide guaranteed interest rates and payments, whereas variable annuities allow you to build tax-deferred capital.
Annuity pros
Many Americans saving for retirement worry they will run out of money. If minimizing risk while securing a specific income amount is your preference, then an annuity may give you the promise of a secure financial future. Annuities can generate income now and into retirement if you select a lifetime contract.
If you choose to increase your payments over time, an annuity may provide inflation protection. Inflation has the potential to significantly decrease your buying power in the future and impact the amount of your total portfolio growth. However, increasing your payments helps you subsidize your income as the cost of living rises.
Investors find annuities appealing due to the hands-off approach and predictability. Since it takes time and skill to manage a stock portfolio, investing in an annuity spares the work involved while offering a measure of security.
Annuity cons
Annuities may seem like a reliable alternative when planning for retirement but they do have some drawbacks. Many financial professionals may view annuities as the ideal retirement solution because they have a good reputation for providing a secure income stream for retirees. However, variable annuities can be costly and unnecessary for a secure retirement.
Annuities are identified as a secure investment, hence yielding lower returns. By investing in a fixed annuity or equity indexed annuity, you’re forgoing the opportunity to earn higher returns like you would with other assets that have volatility. Annuities also don’t provide the flexibility offered by other investment vehicles.
Additionally, some annuities may have high commission rates or management fees. High fees and commissions can cut into the performance of your investment product, in turn yielding even lower returns than you anticipated. If you don’t compare all annuity contracts, you could end up locked into a contract that provides minimal returns.
What is a 401(k)
A 401(k) is a company-sponsored retirement plan. Participants can automatically contribute to their company’s plan with pre-taxed income. Once the participant reaches the retirement age, they will pay taxes on all distributions withdrawn from the account.
401(k) pros
Many employer-sponsored 401(k) plans offer their participants a match program. This means that the company will match each participant’s contribution up to a certain amount. This additional contribution can help build a larger investment portfolio to better support the participant during retirement.
Some 401(k) plans even offer professional financial consultations. Seeking professional guidance can help you select the most suitable investment to meet your goals and objectives.
401(k) cons
Even though 401(k)s have some great benefits, they also have a few downsides. 401(k) plans are often an expensive investment vehicle due to the account management fees and additional costs associated with certain investments. For example, if you select several mutual funds for your 401(k), each of the individual mutual funds may have a maintenance or management fee.
Similar to some annuities, 401(k)s may only provide limited investment options. Many 401(k) plans select certain investments in advance, limiting the investments you can select from. However, these reduced investment options may lessen the complexity of your investment decision.
Which one is right for you?
Now that you understand the basics of each investment vehicle, it's important to know the main differences that set them apart:
• Tax advantages: Both products allow you to delay taxes on your investment growth. However, you contribute to annuities with after-tax dollars while you contribute to traditional 401(k)s with pre-tax dollars. When it’s time to withdraw money in retirement you will pay taxes on your capital gains with annuities, while paying taxes on the total distribution amount for 401(k) accounts.
• Contribution limits: As of 2018, 401(k) participants can only contribute $18,500 annually to their accounts. In 2019, this amount will increase to $19,000. Most annuities do not have annual contribution limits.
• Distribution penalties: Generally, you will have to pay a 10% penalty and income taxes on all distributions taken from a 401(k) before you reach age 59 ½. This penalty is waived for certain qualified expenses such as financial hardship or disability. However, in addition to the IRS penalties, you may be charged a surrender fee from your broker for taking an early distribution from the annuity. Annuities are financial contracts and therefore have increased penalties for withdrawals.
• Loans: If you get into a financial bind, certain 401(k) plans give you the option of taking out a loan from your 401(k). However, most of these loans require you to repay the total amount within 5 years. Annuities do not allow you to take out loans. If you need money, you will have to withdraw directly as a distribution, with the corresponding charges and penalties.
So, is an annuity better than a 401(k)? It depends on your financial needs. There is no “one size fits all” approach to managing your money. When researching the best financial product to meet your retirement goals, compare investment options, fees, tax advantages, and contributions limits.
Keep in mind, you don’t have to select only one option. Contributing to multiple investment products may be the best course of action to achieve a financially secure retirement.