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

When it comes to your retirement, options abound. Two common terms you’re likely to hear around retirement are 401(k) and annuity. While both can be a key part of your plan to fund your retirement, they work in different ways. In many cases, the two can work together to help your savings work hard for you over time.

In the simplest terms, a 401(k) is a type of retirement savings account through your employer that offers tax advantages. An annuity can also help while you’re saving for retirement, but for the most part, annuities are a way to provide reliable income in retirement that you can’t outlive.

Here, we’ll further define the two and show you how each can come together with additional financial tools to help you build a solid retirement plan. We’ll help you understand the differences between the two and why it may be a good idea to consider an annuity and a 401(k) in your retirement plan.

401(k): What it is and how it works

A 401(k) is a retirement savings plan through an employer that provides tax benefits as you save for retirement. Most 401(k)s are traditional accounts, meaning the contributions you make are not taxed at the time you contribute. Rather, you pay taxes on the funds when you withdraw them.

When you take advantage of a 401(k), your employer deducts a portion of your paycheck (based on a percentage that you determine) and invests the money on your behalf, typically in mutual funds, ETFs or other funds that you select. Your employer might also have an employer match, meaning they provide additional funds to match your contribution up to a certain percentage of your income. Your money then has the opportunity to grow tax-deferred until you withdraw it in retirement.

Generally, you can start making withdrawals from your 401(k) at any point after you reach 59½ (you can withdraw sooner, but in most cases, you’ll owe a penalty for doing so). Once you turn 73, the IRS will require that you begin taking withdrawals, at which point you will owe tax on your funds. These are called required minimum distributions. Any withdrawals from your 401(k) will be taxed at your ordinary income rate.

A Roth 401(k) works very similarly to a traditional 401(k); however, instead of making pre-tax contributions, you’d contribute after-tax dollars and can typically withdraw funds tax-free in retirement.

Annuity: What it is and how it works

An annuity is an insurance product issued by an insurance company that can help you in two ways. Certain annuities are designed to help you accumulate funds for retirement, while others are designed to help you generate reliable income that will last for your entire life (no matter how long you live). The specifics of how annuities work, however, vary by the type of annuity. Here are some of the most common types of annuities:

• Income annuities: With an income annuity, you make a large payment to the insurance company, and the company makes regular income payments (typically monthly) usually for the rest of your life. An immediate income annuity would start paying out soon after your lump-sum payment, whereas a deferred income annuity would pay out after a set period of time.

• Accumulation annuities: Accumulation annuities are exactly what they sound like: accounts to accumulate funds for retirement. A fixed annuity will grow at a guaranteed fixed rate. A variable annuity, another type of accumulation annuity, allows you to allocate your funds to sub-accounts that can give you exposure to the financial markets. With an accumulation annuity, you could eventually get your funds back or convert them into an income stream in the future.

Annuities can be purchased with after-tax money or as part of a tax-advantaged retirement plan like an IRA or 401(k). The tax advantages that you can get with an annuity will depend primarily on whether you purchase it with pre- or post-tax dollars.

Is a 401(k) an annuity?

Though an annuity and a 401(k) are both tools for retirement, hopefully you know by now that they are not the same thing.

Similarities between an annuity and a 401(k)

Here are some commonalities between an annuity and a 401(k):

Tax-deferred growth

Both a 401(k) and an annuity offer the opportunity for you to defer paying taxes on retirement funds as they grow. This can result in some significant savings over time. When you contribute pre-tax dollars, you also keep your taxable income lower in the years leading up to retirement, which can minimize your overall tax impact long-term. But remember, you’ll owe tax on that money in retirement.

Early withdrawal penalties

With both an annuity and a 401(k), you could be subject to a 10 percent tax penalty if you withdraw funds before retirement age (59½). In addition, you may face additional penalties from your annuity provider if you withdraw funds from an accumulation annuity prior to holding the account for a certain amount of time.

Income in retirement

Both an annuity and a 401(k) can help fund your retirement. With a 401(k), you do this by making regular withdrawals from your account. An annuity makes monthly payments.

Differences between an annuity and a 401(k)

Because an annuity and a 401(k) are structured differently, there are some key differences in how they work:

Contribution limits

Because of the many tax benefits of doing so, the IRS puts contribution limits on how much you and your employer can put into a 401(k) each year. With an annuity, you can spend as much as you’d like; there are no contribution limits.

Fees

Because they’re managed by an employer, 401(k)s typically have very little or no fees for the investor. (You may be responsible for expense ratios on certain funds, but that’s likely it.) An annuity, however, may potentially have more fees associated with it—especially if you purchase additional riders.

Investment options

Often a 401(k) will offer more investment options than an annuity . In many cases, you may not even have the option to choose investments with an annuity. A 401(k) also has more potential to grow (or shrink), as there is no limit to what you can gain or lose with a 401(k). Though some types of annuities can also achieve notable growth, many types of annuities cap gains and losses on the annuity fund.

Liquidity

Though you’d be subject to tax penalties for withdrawing money early from a 401(k), a 401(k) offers the option of taking a loan from the account if you need funds before reaching retirement age. Each 401(k) plan is different, but generally, you may be able to take as much as 50 percent of your savings (up to $50,000) within a year. If you pay the loan back (with interest) within a certain time frame, you may not have to pay any added fees on your early 401(k) withdrawal.

With an annuity, however, this isn’t always the case. With some annuities—like an accumulation annuity—you may be able to withdraw funds early, but you’d face penalties for accessing funds before a certain point. Other annuities, like an income annuity, may not allow you to access your money at all (other than receiving the regular annuity payments).

Inheritance

Generally speaking, once you die, your annuity payments will stop. There are certain types of annuities, like a joint and survivor annuity , for which this would not be the case. You can also add a death benefit rider to an annuity that would either ensure that a beneficiary would continue to receive your payments for a certain period of time or give the beneficiary a death benefit payment if payments hadn’t started yet.

A 401(k), on the other hand, can be passed down as part of an inheritance when you die. So, even if you haven’t completely drained the account, you wouldn’t completely lose the money. You could leave it to your heirs (though depending on how old you are when you die, you may not be passing much on to them).

Income guarantee

If you’re making regular contributions to your 401(k), you’d like to believe that you’ll have guaranteed income in retirement—however, this isn’t a guarantee. Because your funds are tied to the market, they can rise or fall depending on the market’s performance. And depending on how much you have saved, your money may not cover you for the rest of your life—especially if you end up retiring early and living for a long time. This is one reason people will add an annuity to their retirement plan: so they don’t outlive their savings.

An annuity promises to provide a regular income as long as you live. In fact, if you live long enough, you may even end up receiving more than you paid in as the annuity pays out over time—one of the benefits of an annuity.

Is it possible to move funds between an annuity and a 401(k)?

Because both have tax advantages, there may be instances in which these funds could interact with one another. However, this isn’t always possible and will depend on your specific plan or policy.

To some extent, yes, you could transfer funds from one financial product to the other in some instances. You could use funds in a 401(k) to purchase an annuity (either within the 401(k) or outside it).

Can you roll over a 401(k) into an annuity?

You may be able to move funds from a 401(k) to an annuity (or purchase an annuity through your 401(k)), as long as your plan allows it. In this instance, an annuity could be funded only with a qualified retirement account, which means it follows IRS tax code, making it eligible for tax benefit s.

Though using 401(k) funds to buy an annuity can be a tax-smart way to shield against market volatility and guarantee income in the future, it could limit your potential for future growth. An annuity already offers tax-deferred growth, so you’ll probably want to hold any investments in a tax-advantaged account vs. an annuity until you approach retirement. But you’ll really want to weigh nuances of your situation when deciding whether to roll 401(k) funds into an annuity.

Can you roll over an annuity into a 401(k)?

A 401(k) can contain assets like an annuity, but generally, moving an existing annuity into a 401(k) is not something most plans allow. Depending on your plan provider, you may, however, be able to roll an annuity into an IRA or purchase an annuity through a 401(k).

Should you choose an annuity or a 401(k)?

Buying an annuity can be a great way to ensure you don’t outlive your savings in retirement; however, while you’re saving for retirement, an annuity may or may not make sense for you depending on your situation. But as you approach retirement, you’ll likely want to consider using some of your savings to add an income annuity to your plan to guarantee a portion of your income. But it really is a personal decision that should be looked at on a case-by-case basis.

You also don’t need to choose between an annuity or a 401(k): You can have both. In fact, doing so can be a strategic financial move, as it can diversify your sources of income in retirement.

Designing your retirement plan is truly an individual exercise that can be extremely beneficial to get help with. A Northwestern Mutual financial advisor can help you design a plan that suits your financial situation and helps you achieve your financial goals—before, during and after retirement. An advisor can also show you how all your financial tools can work together to minimize your tax impact and maximize the retirement savings you worked hard to build.