Annuity vs 401(k)

An annuity is a financial instrument that is used to generate income for an individual who has already retired. When investing in an annuity, the investor contributes money into an account that will be used to purchase retirement income products or annuities.

To fund an annuity, the investor has two options: (1) the annuity can be funded through a lump sum payment or (2) installment payments into an annuity fund. The more money that is contributed, the higher the monthly income will be for the individual in their retirement years.

If one chooses to invest in an annuity via installments, they must make sure to continue making payments until they reach retirement age and withdraw from the account. If this does not happen, then there will be no monthly income provided by the investment.

A 401(k) plan can be defined as an employer-sponsored program in which employees are offered the opportunity to contribute a percentage of their earnings before taxes. This money is then invested in different investment vehicles.

Once the funds have been placed into this account, they will be able to grow tax-deferred over time until retirement when withdrawals are granted to the investor who set up the plan.

In order to set up a 401(k) plan, an employee must contribute a certain percentage of their income before taxes into the account. The amount that can be contributed is dependent on how much money has been earned by the individual in a given year.

Differences Between Annuity and 401(k)

The major difference between annuities and 401(k) plans is that with an annuity, the individual invests his/her own money while a 401(k) comes from an employment source.

An additional distinction is that with an annuity, the individual has to make investments with his/her own money while a 401(k) is set up by an employer.

In terms of withdrawal, an annuity is often at the discretion of the insurance company while with a 401(k) plan, it is not.

A 401(k) will make the employee pay for a 10% early withdrawal penalty if funds are withdrawn prior to reaching the age of 59.5 years. While for annuities, early withdrawal fees are being set by the insurance company.

Both annuities and 401(k) plans are usually tied to an individual’s tax bracket; however, the amount that can be sheltered in an annuity account for retirement purposes is capped.

Furthermore, 401(k)s allow borrowing of funds while annuities don’t.

Which Is Better for Retirement?

When it comes down to which product is better for retirement, there are many factors that could possibly be considered (and will depend on the situation of each person).

For example, if an employee feels like they would like more freedom over their investment choices, then investing in something like a 401(k) might be preferred.

However, since annuities do not require employees to contribute as many before-tax earnings into retirement accounts as does a 401(k) plan, individuals can have larger amounts available for use later in life.

In the end, though, the best option will always depend on what works best for an individual’s particular situation.

If you are a business executive or a business owner, you may want to consider looking into annuity options as a way of securing your financial future and providing for your family both now and in the future.

Regardless of what type of annuity is chosen, always remember to look at all the available options before making a final decision since different products will work for different people.

Annuities can be used as part of an overall retirement strategy but never as the only option. Having other types of investments to distribute the money among can also help ensure that there will be enough funds available later on if circumstances change unexpectedly.

Final Thoughts

Annuities and 401(k)s are both good ways of securing a retirement plan. Depending on your situation, you can choose from several different types of annuities–fixed annuities, variable annuities, index annuities–to get the most out of your investment.

In addition to not having to pay taxes on the earnings from an annuity, you could receive a steady stream of payments for as long as you live.

If you are interested in finding the right annuity and reviewing your options, you should talk to a financial advisor who can help you determine what is best for your specific financial situation.

There are several benefits to getting an annuity, including a steady stream of income during retirement, access to a variety of different types of annuities, and the fact that they can be purchased with after-tax dollars.
In order to get started with an annuity, you will need to speak with a financial advisor who can help you determine which type of annuity is right for your specific needs.
The primary difference is that with a fixed annuity, the individual knows exactly what they are going to get in terms of income. Variable annuities are more likely to see retirement funds increase or decrease depending on investment gains or losses.
Whether you choose annuity or 401(k), really depends on your situation. For example, (k) might be better for people who want to have more control over their investment choices and prefer a diversified portfolio. On the other hand, an annuity could end up being a better option if someone is looking for guaranteed retirement income that does not fluctuate.
You can get an annuity from an insurance company. They may be willing to negotiate the interest rate or annuity payout. So, speak to an agent or insurance company representative about various annuities and request information on their retirement plans.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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