Annuities and 401(k) plans are two commonly used retirement accounts in America. They both have a similar design in their tax benefits and their rules for withdrawals. While the two plans have many similarities, they do have some significant differences as well. By understanding these differences, you can decide which account is best for you.
TL;DR (Too Long; Didn't Read)
Some differences between annuities and 401(k) plans lie in availability, plan limits, tax benefits, surrender fees, loan options and taxation of withdrawals.
Availability of These Plans
Not everyone can invest in a 401(k). You can only invest in a 401(k) if you work for a company that offers one. If you quit your job, you won't be able to add any more money to your old 401(k).
Annuities are not a work-sponsored retirement plan. There are no restrictions on adding money, and you can invest in an annuity whenever you want.
Annual Contribution Limits
There is a limit to the amount you can add to your 401(k) per year. As of 2019, you can only invest up to $19,000 a year into your 401(k). When you turn 50, you can invest up to $25,000 a year. There is no limit to the amount of money you can invest in an annuity.
The Tax Benefits
The 401(k) has better tax benefits than the annuity. Both accounts delay taxes on your investment growth. You don't need to pay tax on your investment gains until you take money out in retirement.
However, the 401(k) offers an extra tax benefit. You can deduct your 401(k) contributions from your taxes for the year. This lowers your taxes for today while saving money for the future. You cannot deduct your annuity contributions; it only offers the tax delay on your investment gains.
Taxation of 401(k) Withdrawals
When you take money out of a 401(k), the entire withdrawal is taxable. When you take money out of an annuity, only the investment gains are taxable. Since you funded the annuity with after-tax money, you get your contributions back tax-free.
Both accounts penalize early withdrawals. If you take money out when you are younger than 59 1/2, you will likely owe an extra 10 percent penalty. Once again, this penalty applies to the entire 401(k) withdrawal, whereas it only applies to your annuity gains.
Annuity Surrender Fees
Annuities charge an extra fee that 401(k)s do not. When you buy an annuity, you are signing a long-term contract with an annuity company. If you need to withdraw your money or cancel the contract early, you may need to pay an early surrender fee. This is on top of any taxes or penalties you owe to the IRS.
Most annuity companies charge a surrender fee for the first five to seven years of a contract. You don't have to pay an extra fee to your investment company when you pull money out of your 401(k).
401(k) Plan Loans
Some 401(k) plans offer loans. They let you borrow your savings before retirement and avoid paying taxes or penalties. If your plan offers loans, you can borrow up to $50,000 from your account. You generally need to repay the loan within five years to avoid paying taxes and withdrawal penalties, although you can use a longer repayment schedule if you withdraw the money to purchase a home.
Annuities do not offer loans. If you want to take out money, it needs to be a withdrawal.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.