Annuity vs. 401k: What’s the difference?

Written by

Edited by

Published on June 27, 2024 | 4 min read

Bankrate is always editorially independent. While we adhere to strict , this post may contain references to products from our partners. Here's an explanation for . Our is to ensure everything we publish is objective, accurate and trustworthy.

Our writers and editors used an in-house natural language generation platform to assist with portions of this article, allowing them to focus on adding information that is uniquely helpful. The article was reviewed, fact-checked and edited by our editorial staff prior to publication.

When planning for retirement, it’s crucial to understand the financial tools available to you. Two of the most commonly used retirement savings vehicles are annuities and 401(k) plans. While they share some similar features, such as tax-deferred growth, they are fundamentally different in their structure, benefits, and potential drawbacks.

In this article, we’ll break down the key similarities and differences between annuities and 401(k) plans, helping you make an informed decision about your retirement savings strategy.

Annuity vs. 401(k): How they compare

A 401(k) plan is a type of retirement account, while annuities are financial products sold by insurance companies. A 401(k) plan is a structure that allows you to save and invest over time, while annuities are products that are often designed to provide guaranteed income during retirement. Both can play a role in saving for retirement, but they have some key differences.

Here’s how annuities and 401(k)s are similar and different.

Similarities between annuities and 401(k)s

Despite their distinctive characteristics, annuities and 401(k) plans share several core features that make them appealing choices for retirement savers. Here are a few of their similarities:

Tax-deferred growth: Both annuities and 401(k)s can offer tax-deferred growth. This means you won’t pay taxes on your earnings until you start withdrawing funds or receiving payments, potentially boosting your savings over time.
Penalty on early withdrawals: Both these financial vehicles impose penalties on withdrawals made before age 59½, though there are some exceptions. Annuities may charge surrender fees if you want to access your funds early, which eats into your return.
Easy transfer of wealth: Both annuities and 401(k)s allow assets to bypass probate if you’ve designated a beneficiary, simplifying the process of transferring wealth to your heirs.

Differences between annuities and 401(k)s

While annuities and 401(k) plans share some similarities, they diverge significantly in other areas, each offering unique benefits and drawbacks. Let’s delve into their key differences:

Tax benefits: Contributions to a 401(k) are typically made with pre-tax dollars, reducing your taxable income for the year. In contrast, annuities are usually purchased with after-tax money, though they can also be funded with pre-tax money from a 401(k).
Contribution limits: Unlike 401(k) plans, which have an annual contribution limit set by the IRS, annuities have no such limits, allowing for potentially larger investments. If you’ve already maxed out your 401(k) contributions, you may want to use annuities as a way to save even more.
Investment options: 401(k) plans often provide a range of investment choices such as mutual funds and ETFs. Annuities, however, are contracts with insurance companies that can be complex and may offer fixed, variable or indexed returns.
Withdrawal rules: You can start withdrawing from a 401(k) without penalty at age 59½, while annuities may have early withdrawal fees, including surrender charges that decrease over time.
Employer involvement: 401(k) plans can include employer contributions, often matching a portion of the employee’s contributions. Annuities, however, are typically purchased individually through insurance companies, with no employer match.
Payout structures: 401(k) plans offer flexibility in how and when you can withdraw your funds. Annuities provide a guaranteed income stream, either for life or a set period.

Understanding the pros and cons of annuities compared to a 401(k) is crucial to making an informed choice that aligns with your retirement goals, risk tolerance and financial circumstances.

Should you choose an annuity or 401(k)?

The choice between an annuity and a 401(k) plan largely depends on your individual financial situation, risk tolerance and retirement goals. If you’re seeking potentially high returns, a variety of investment options and the benefits of employer-matching contributions, a 401(k) might be the right choice.

On the other hand, if you prioritize a steady, guaranteed income during retirement and are less concerned about achieving high growth, an annuity may be more suitable. Keep in mind that 401(k) plans offer more potential for growth, but they also carry more risk as they are subject to market volatility.

Annuities can provide peace of mind with a guaranteed income, but they often come with higher fees and less flexibility. Therefore, it’s crucial to weigh the advantages and disadvantages of each option carefully and consider consulting with a financial advisor to tailor a retirement strategy — which may include both a 401(k) and an annuity — that aligns with your financial goals and risk tolerance.

Should you buy an annuity with your 401(k)?

Another option is to buy an annuity with funds from your 401(k). This strategy involves rolling over your 401(k) to an annuity tax-free, providing a steady and reliable income stream during retirement.

However, purchasing an annuity with 401(k) funds can come with its own set of considerations. Annuities often have higher fees and are less flexible than 401(k) plans. Early withdrawals from an annuity may also face surrender charges. Furthermore, the returns on annuities may be lower than other investment options, particularly if you prioritize growth over guaranteed income.

In contrast, a 401(k) plan often offers employer matching contributions, a broader range of investment choices and potentially higher returns. However, it also carries the risk of market volatility and the possibility that you may run out of money one day. Therefore, combining both 401(k) plans and annuities can offer a balanced approach, leveraging the strengths of each to mitigate their respective weaknesses.

Bottom Line

When it comes to planning for retirement, understanding the similarities and differences between annuities and 401(k) plans is crucial. While both can offer tax-deferred growth, they have distinct features and potential drawbacks. Choosing between them depends on your individual financial situation, risk tolerance and retirement goals.

It may also be beneficial to consult with a financial advisor to tailor a retirement strategy that aligns with your needs. Combining both annuities and 401(k) plans can offer a balanced approach and help ensure you have income to meet your spending needs while also generating portfolio growth. Ultimately, the key is to make an informed decision that sets you up for a comfortable and secure retirement.