Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider before rolling your 401(k) into an annuity. In addition to the sometimes hefty fees incurred by annuitants, you risk losing part of your investment if you die prematurely (in this case, you may no longer be able to pass the remainder of the annuity on to your beneficiaries). Many insurance companies tout the tax benefits of annuities. However, a traditional 401(k) is already tax-sheltered and a delayed rollover could cost you in taxes.
The chief benefit of annuities is they provide guaranteed income. Though there are some important differences between the income generated by fixed versus variable annuities, the majority of annuity investments are made by people looking to ensure they are provided for in later life. However, you are likely to incur some substantial expenses just for the privilege of owning an annuity in addition to your capital investment.
The specific fees charged by your insurance company vary with the type of investment you choose. Variable annuities tend to have higher fees than their fixed counterparts because they require a more active, engaged management style. Annuities that protect your principal or guarantee your balance cannot decrease carry even higher fees, often around 2 to 3% annually. These fees cover management and administrative expenses incurred throughout the year. However, you likely pay an additional annual fee to offset the risk the insurance company assumes in selling you an annuity, such as the risk you will live longer than expected. Other fees may be one-time up-front costs, such as a sales fee to cover the commission of the person who sold you the annuity, or a contract fee. Though these expenses seem small individually, they can quickly drain your retirement funds over time.
If you decide an annuity is no longer the right investment for your needs and want to withdraw your initial investment, you incur a serious surrender charge. This charge typically starts at 7% and gradually decreases over the first seven to 10 years of account ownership.
Risk of Loss
If you die before you use up your 401(k) savings, your named beneficiary inherits the account just like any other asset. If you die before you receive full benefits from your annuity, however, the insurance company may end up keeping the remainder of your savings. Many annuities offer the option of having the contract pay over the course of your life and then transfer to your spouse if you die prematurely. This feature generally comes at an additional premium so your savings may be at risk if you do not read the fine print.
Many financial advisors recommend annuities because your investment grows tax-deferred, meaning you pay no income tax on your gains until they are withdrawn. However, if your investment capital is already in a traditional 401(k) or IRA account, a rollover to an annuity offers no additional tax benefits. Earnings on 401(k) funds are already tax-deferred, as are your original contributions. As with an annuity, you do not pay income tax on your contributions or interest until you withdraw those funds after retirement.
Another risk to consider when rolling over your 401(k) into an annuity is the tax implications of the rollover itself. While the IRS allows for tax-free rollovers from qualified retirement plans, you must complete the transaction within 60 days or risk forfeiting 20% of your balance. Any amount you do not roll over is taxable as ordinary income, which can substantially increase your tax liability for the year.
Adam Harding, CFP®
Adam C. Harding, CFP Investments & Financial Planning, Scottsdale, AZ
There are a multitude of risks to rolling a 401(k) into an annuity. An important one to consider is that with an annuity, you are limited to the investment options within the annuity, or, in the fixed annuity case, interest rates are historically low and your guaranteed payout is tied in some manner to current interest rates. You will also have an inflexible monthly income.
The reality of retirement is that some months are expensive and others are not. If you had a period of heightened expenses (such as paying for long-term care), you may not be able to increase your income from the annuity. There are situations where annuities are good for investors, but I have never recommended that anyone roll qualified assets into an annuity. It’s important to do your research and seek multiple opinions.