Saving enough money to retire happily is only one part of a well-rounded retirement plan. Another important part of the planning process is deciding what to do when you retire. For example, you might have accumulated a significant nest egg in your 401(k). You can invest that money in stocks and bonds, but you have no guarantee your money will be safe. Alternatively, you could roll over your 401(k) into an immediate annuity, which offers a secure lifetime income.
When you purchase an immediate annuity with your 401(k), you're handing over control of your nest egg -- or at least part of it -- to an insurance company. The insurer calculates your likely lifespan, and agrees to pay you a set amount each month for as long as you live. You can also choose to structure your annuity so it provides an income for your spouse, and pays as long as either of you is alive. If you outlive your money, the insurance company will dip into its own pockets to ensure those guaranteed payments last as long as you do.
The Bad News
Guaranteed income for life sounds pretty appealing, but there's another side to the picture. First, you're giving up control of your capital to the insurer. Once you've purchased the annuity and begun receiving payments, you can't back out. Second, payments can be very low. That's especially true if you purchase your annuity at the relatively young age of 60 or 65, or if it's a joint annuity with your spouse. The insurer could be paying for 30 or 40 years, and will calculate a large margin of error in case you prove to have good longevity genes. That means more of your money sits in the insurer's portfolio, and less reaches your bank account.
You can choose a number of strategies to cope with those shortcomings. For example you could put one portion of your 401(k) into an immediate annuity, and use the rest to purchase mutual funds and other investments within an IRA. That way you continue to have control over a large portion of your capital, but still have a safety net of guaranteed income. Another alternative is to purchase a deferred annuity, rather than an immediate annuity. With a deferred annuity you postpone taking an income until later, which raises your monthly payments.
To avoid triggering a taxable distribution, you'll need to have your employer transfer the funds for you. The annuity you purchase is considered a "qualified" plan, or IRA annuity. Your employer simply transfers your capital into the new annuity, without having to withhold any funds. You'll pay taxes only on a portion of the income you actually receive during the taxation year. Part of each payment is considered to be a return of your premium, with the remainder being your gains. Those are taxed as ordinary income. If you're below the age of 59 1/2 when you begin drawing an income, you'll pay an additional 10 percent levy on the taxable portion.
- CBS MoneyWatch: IRA and 401(k) Drawdown -- Just Tell Me What to Do for Immediate Annuities
- CNN Money: Income for Life -- Slicing Up Your Savings
- Reuters: Is an Annuity in Your Future?
- Financial Industry Regulatory Authority (FINRA): Smart 401(k) Investing—Managing Income in Retirement
- Immediate Annuities.com: Take Advantage of the Tax-Free Rollover Rules to Move Your IRA or 401k into an Annuity
- Annuity FYI: 401k Rollover — is It Right for Me?
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- How Does a Split Annuity Work?
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- What Happens When I Sell an Annuity Fund?