Annuity vs. 401(k): What’s The Difference? 

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One of the most appealing features of retirement planning is the multiple options for accruing wealth. Two popular options are 401(k)s and annuities, each one comes with distinct benefits. There is no definitive answer as to which choice is best — it depends on your financial situation and goals. Learn what distinguishes these two retirement investments to establish which one suits your needs. 

What Are 401(k)s? 

Most working adults in the United States participating in an employer-sponsored retirement plan have a 401(k). Created by Congress, 401(k)s prompt workers to invest in their retirements by offering tax benefits for those who save. Essentially, the employee has a percentage of every paycheck moved into an investment account. 

401(k)s are defined contributions plans, meaning the employer and employee add to the account. The Internal Revenue Service (IRS) sets the dollar limits for these contributions, and employers determine how much they will match. 

With 401(k) investing, employees are given a list of options, including stocks, bonds, and mutual funds. Each investment type offers varying levels of risk and earning potential. Some plans also feature guaranteed investment contracts (GICs) and employer stock. 

The amount you contribute each year, the investments you choose, and how many years you have until retirement dictate how much money you have in your 401(k). 

Types of 401(k)s 

For a while, the traditional 401(k) was the only option available for American workers. However, the Roth 401(k), introduced in 2006, is becoming a more popular option at many companies. While both plans offer a tax break and ensure your investments stay exempt from taxes while you work, they differ in several key ways. 

In a conventional 401(k), employee contributions come from gross income (the money they make before income tax deductions). This system decreases the employee’s taxable income, enabling them to report a tax deduction for that year. Neither the money you contribute nor your investment earnings incur a tax until you make a withdrawal. For this reason, employees in lower tax brackets may find the traditional 401(k) a better option as it provides an immediate tax break.

Roth 401(k)s collect contributions from the net income after taxes. While this approach does not permit employees to deduct taxes, it allows them to withdraw tax-free in retirement, provided they meet age requirements or special conditions. This exemption applies to your contributions and any investment earnings. The Roth 401(k) tends to favor those in a higher tax bracket since it diminishes current spending power. 

What Are Annuities? 

An annuity is a contract between the investor and an insurance company designed to provide a reliable source of income in retirement. As the investor, you provide the insurance company with a lump-sum payment or establish a schedule to make regular payments for a set period. In exchange, the insurance company extends disbursements that either begin right away (immediate annuity) or in the future (deferred annuity). 

The period of your disbursements varies based on your needs. You may choose a lifetime of payments or opt to receive payouts for a select amount of time, like 30 years. While obtaining a lifetime of payments may reduce the amount of each check, it can provide security since your assets will outlive you. 

Types of Annuities 

While annuities share some similarities, they also differ in significant ways. The following are five kinds to consider: 

  • Fixed annuities: These provide investors a guaranteed payout, irrespective of market fluctuations. In exchange for this security, they tend to bring a moderate return. 
  • Variable annuities: Like a 401(k), a variable annuity allows investors to choose mutual funds that go into a sub-account. They present the potential for a higher return, but also the risk of losing money. 
  • Index annuities: These are the middle ground between fixed and variable. They are connected to a specific market index and feature a guaranteed minimum payment. However, they also have the potential for more growth than fixed annuities. 
  • Single premium immediate annuities (SPIAs): Ideal for those purchasing annuities at the start of retirement, SPIAs involve making a lump-sum payment in exchange for immediate disbursements. 
  • Qualified longevity annuity contracts (QLACs): These annuities guard investors against outliving their funds and suspend required minimum distributions (RMDs). 

How 401(k)s and Annuities Differ 

From tax-deferred growth to long-term savings, 401(k)s and annuities share attractive features for retirement investors. Yet, they also have notable differences that may impact which direction you go with retirement planning. Key contrasts between the two include: 

  • Access to principal amount: If you need to close your 401(k) early, you usually can take out a loan to bypass withdrawal penalties. Conversely, you may incur surrender charges and lose some of the principal if you liquidate an annuity early. 
    • Contribution limits: 401(k)s have caps on contributions, while annuities do not. 
  • Employer match: Employers can only contribute to 401(k)s, which may enhance your retirement savings. 
  • Fees: You may be charged by an insurance company to get an annuity, but 401(k)s have no fees. 
  • Guaranteed returns: 401(k)s cannot promise guaranteed income like some annuities. 
  • Investment options: Annuities tend to offer a wider selection of investments than 401(k)s. 
  • Restrictions on returns: While 401(k)s generally do not limit gains or losses, many annuities do.

Seek Guidance with Retirement Planning 

Whether you choose a 401(k) or annuity, you can find expert retirement planning advice from Park Place Financial. Our team employs a well-constructed process and financial strategies backed by hard data and academically validated principles, looking at all aspects of your financial situation to make the most informed recommendations. Contact us today to learn more about our retirement planning services or request a complimentary financial checkup


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