One of the sad facts about retirement planning is that it involves a lot of compromises. It's nice to think about retiring earlier and enjoying a relaxed, affluent lifestyle rather than just getting by. Of course, the combination of a shortened work career and higher expectations for retirement are on a collision course, especially when you allow for the constant increase in life expectancy. That makes it all the more important to take every advantage you can when you're investing for retirement. Finding tax-free growth for your investments is one major advantage offered by both annuities and your 401(k).
Surviving on your Social Security check isn't anybody's idea of a good time, so retirement planning is a big priority for a lot of couples. Affluent, free-spending seniors are better for the economy than indigent seniors using the social safety net, so the government is equally motivated to help you. That's why they don't tax the growth of your retirement investments in an annuity, IRA or 401(k). This preferential treatment is a significant benefit, allowing more money to remain in your investments each year and turbocharging their growth. Most books on financial planning include examples that illustrate the dramatic difference this makes after a period of decades.
Annuities behave differently from other investments in some respects. They're essentially a mutant form of life insurance, designed to provide an income for as long as you live instead of a lump sum when you die. You can buy one with a single payment or pay into it for years as you would with an IRA or 401(k). They typically cost more than other investments and have lower returns. Fixed annuities provide a straightforward, contractually guaranteed income. Variable annuities trade that certainty for higher potential returns, investing in mutual funds or other mainstream products that can go up or down in value.
Your 401(k) is a workplace savings plan, available in conventional and Roth versions. The conventional version allows you to deduct each year's contributions from your taxable income, while the Roth version uses after-tax dollars. However, your retirement income from a conventional plan is taxable, while the Roth plan's payouts are not. Employers often match your contribution to a 401(k), providing an increased return on your investment. Unlike an annuity, your 401(k) isn't an investment in itself. Instead, it's a sort of tax-exempt wrapper you can use to hold most investment products, including stocks, bonds, mutual funds and exchange-traded funds.
Pros and Cons
Your tax-advantaged investment comes at a cost since both annuities and 401(k) accounts typically have higher management costs than investing directly in stocks or funds. Annuities often have lower returns, as well as high costs. However, there's a limit to how much you can contribute to a 401(k), while annuities offer unlimited contributions. Control is another important consideration: Your employer determines which investment options are in your 401(k), and an annuity offers pre-selected investment options as well, unlike an IRA, in which you can invest in almost anything. You must start drawing a specified minimum from a 401(k) or traditional IRA at age 70 1/2, while a Roth 401(k) or annuity has no such restrictions.
The Right Choice
If you anticipate that your tax bracket is higher now than it will be in retirement, it makes sense to contribute to a conventional 401(k). You'll get a tax break now and pay at a lower rate when you withdraw. If the reverse is true, a Roth 401(k) might be a better choice. If your employer matches your contributions, that's a strong argument for a 401(k) over an annuity. However, if you contribute your maximum to the 401(k) and would like additional sheltered growth, an annuity might be a good choice. Funds in an annuity can also be paid directly to your named beneficiary after your death, bypassing probate.