If you have a 401(k) plan, you are probably aware that you can use it to invest in a wide variety of funds—target-date funds, passively managed index funds, and actively managed mutual funds. Some plans, however, also allow you to access other financial product types, such as annuities.
An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.
Annuities can be a good way to fund retirement for some people, but they are not that common in 401(k) plans. Though they are becoming more common, as of 2020, only 16.3% of retirement plan participants are offered retirement income options. One reason for this: Employers ultimately have a responsibility to ensure that they offer “prudent” investments through their 401(k) plans, and offering annuities entails the risk that an insurance company might go bankrupt. Therefore, plan sponsors may be concerned about being sued. The Setting Every Community Up for Retirement Enhancement (SECURE) Act reduced this risk and made annuities a safer option for employers, but they remain an unusual choice.
If your 401(k) does offer annuities, however, they could be a good option for retirement, depending on your circumstances. In this article, we’ll look at the pros and cons of adding annuities to your 401(k) account.
- If you would like to buy an annuity as part of your retirement portfolio, you may be able to do so through your 401(k). Some employers allow employees to buy annuities via their 401(k) plans; others do not.
- If you can buy an annuity in this way, it may offer advantages. You may get a better rate than what’s available for annuities on the open market, and your employer may well have vetted the annuity provider to reduce your risk.
- On the other hand, since annuities offer the same tax benefits as 401(k) accounts, it’s often better to buy annuities with money that otherwise would be taxed—assuming that you have enough outside your 401(k) to afford this.
Types of Annuities for Your 401(k)
Before you put an annuity in your 401(k), it’s worth making sure that you understand the different types that may be available to you. This is important because the options can be complex. Beyond a simple fixed immediate annuity, you might be able to buy a far more complicated and expensive variable annuity, or a slightly less complicated and expensive indexed annuity.
Another popular choice is a qualified longevity annuity contract (QLAC). This is a type of advanced life deferred annuity funded with an investment from a qualified retirement plan, such as a 401(k) or an individual retirement account (IRA). Beginning Jan. 1, 2022, an individual can use up to $145,000 of their retirement savings account to buy a QLAC. The advantage of a QLAC is that the required minimum distributions are tax deferred.
Annuities can be a good choice for your retirement portfolio, but this depends on your circumstances and risk tolerance. It’s important to understand this before you buy one, whether through your 401(k) account or in another way. Read our guide to annuities to make sure that this is a good option for you before purchasing one, because getting your money out of an annuity after you’ve bought it can be tricky and expensive.
Advantages of Buying an Annuity in Your 401(k)
If you’ve decided that an annuity is right for you, you may have several options for how to buy one. Here are the advantages of doing so via your 401(k):
- Potentially higher payouts. Your employer may have more weight when it comes to negotiating annuity rates, so the money you receive for an annuity option in your 401(k) might be higher than you can get on the open market. It might not be, though, so make sure you check each option carefully.
- Non-gendered pricing. Annuity prices normally reflect life expectancy, and women live longer on average. For annuities offered on the open market, this means that women can expect a lower monthly payout. In a 401(k), all participants must be offered the same prices and deals, making this a better deal for women (and, potentially, a worse deal for men).
- Peace of mind. The annuity provider is likely to have been carefully vetted by your employer, which has fiduciary responsibility for the security of your plan.
- Finally, it may be that you have no choice but to take this route if you want to buy an annuity. By the time that annuities become a valuable option, many seniors find that the majority of their assets are tied up in their 401(k), making this the most convenient way of buying an annuity without a complex (and potentially expensive) property refinance.
Disadvantages of Buying an Annuity in Your 401(k)
As with every investment decision, there are also potential downsides to buying an annuity via your 401(k). Some of these are the same whether you buy an annuity via your 401(k) or on the open market—annuities typically offer lower growth than stocks or exchange-traded funds (ETFs), and it can be difficult to get money out of an annuity while still in the accumulation phase.
Perhaps the biggest disadvantage of buying an annuity via your 401(k), however, is that doing so reduces some of the tax advantages of having a 401(k) account. That’s because annuities have the same tax-deferral benefit that 401(k)s have, and it works in the same way. You don’t pay taxes on the growth in an annuity—or on the money in a 401(k)—until you take the money out.
Because of this, it may not make sense to buy an annuity in an account where you already get the benefit of deferred taxes. If you can, you should use money that’s in a taxable account to buy an annuity. However, many people don’t have the funds in a taxable account to buy an annuity, so you may have little choice but to use your 401(k) account if you want an annuity.
Can I buy an annuity for my 401(k)?
It depends on your employer. Some plan sponsors are wary of offering annuities as part of their 401(k) plans, while others are happy to do so.
What types of annuity can I buy for my 401(k)?
Again, it depends on your employer, but you may have several options. Beyond a simple fixed immediate annuity, you might be able to buy a far more complicated and expensive variable annuity, and the slightly less complicated and expensive indexed annuity. Another popular choice is a qualified longevity annuity contract (QLAC), which has tax advantages.
Should I buy an annuity for my 401(k)?
It depends. First, you should make sure that an annuity makes sense for your retirement portfolio. Then look at how you can buy one. Buying an annuity via your 401(k) may allow you to access a better rate than on the open market; on the other hand, you’ll miss out on some tax advantages.
The Bottom Line
If you’d like to buy an annuity as part of your retirement portfolio, you may be able to do so through your 401(k). Some employers allow employees to buy annuities via their 401(k) plans, but others do not.
If you can buy an annuity in this way, it may offer advantages. You may get a better rate than what’s available for annuities on the open market, and your employer may well have vetted the annuity provider to reduce your risk. On the other hand, since annuities offer the same tax benefits as 401(k) accounts, it’s often better to buy annuities with money that otherwise would be taxed—assuming that you have enough outside your 401(k) to afford to do so.