One of the biggest decisions anyone has to make for retirement is where to invest money. If you ask 10 different financial advisors, there is a 100% chance you’ll get 10 different answers. This is evidence that you have plenty of options, including two popular choices like annuities and a 401(k). 

While both of these share some similar features, like both can be tax-deferred, they are also very different in how they are structured. As a result, many people choose one over the other, and this approach can make all the difference in how much you have to retire down the road. 

Key Features of Annuities 

If you’re looking at taking out an annuity, you are likely doing so to guarantee an income stream down the road in exchange for a series of payments. Annuities are basically specialty products that provide a secure and steady income while retired. So, what types of annuities are available? 

Fixed 

Choosing a fixed annuity guarantees an interest rate and a predictable payment schedule. This is considered the lowest-risk option in the annuity world, and insurance companies offering fixed annuities are likely to guarantee both income and interest rates throughout the contract term. 

Variable 

When you select a variable annuity, you want income payments based on any investments considered part of the annuity, generally a mutual fund. Variable annuities are risky because the payments and any rate of return will vary, making them both higher risk and with the potential for greater returns. 

Indexed

If you go with an indexed annuity, you are hitching yourself to something tied to a market index, likely the S&P 500. Like a variable annuity, indexed annuities are risky in that both offer payments and interests directly tied to the performance of the chosen index. Indexed annuities often come with an interest rate cap, which means there is a maximum rate of return. 

Annuity Pros and Cons

For anyone looking at an annuity as a potential investment option for retirement, it’s essential to consider its advantages and disadvantages. Its biggest pro is that you guarantee yourself an income stream and financial security while retired. The payments for an annuity are based on your lifespan, so you’ll continue receiving payments as long as you are living. 

Another pro is that any growth is tax-deferred, which means you won’t pay taxes on any earnings until you start receiving payments. The last major pro for an annuity is that you have some protection against market volatility. With insurance companies guaranteeing income and interest rates, you know you have at least a minimum level of payment available. 

Conversely, you may have higher fees, which means higher monthly and annual payments. There are also more significant penalties if you want to withdraw money from an annuity before your term payouts begin. In some cases, you may also see less financial growth than other retirement options, like a 401(k) that is more closely tied to market gains. 

Key Features of 401(k)

There is a good chance that if you are even remotely considering retirement, someone has mentioned a 401(k) plan to you. These employer-sponsored plans enable employees to save and invest a portion of their salary, with employers traditionally offering a matching percentage of the employee’s contribution. 

Traditional 401(K)

A traditional 401(k) is the most common, and it allows contributions to be made with pre-tax dollars on your earnings, which reduces how much you are taxed at the end of the year. You don’t pay any taxes on this money until you begin making withdrawals. 

Roth 401(k)

The biggest alternative to a traditional 401(k) is that any contributions are made with after-tax dollars, which means that any withdrawals you make during retirement are tax-free. If you are in a higher tax bracket during retirement, a Roth 401(k) may be for you. 

Solo 401(k)

For anyone self-employed or small business owners who work for themselves, a Solo 401(k) allows higher contribution limits since you are both the employee and employer. 

401(k) Pros and Cons

Without question, the biggest reason to pick up a 401(k) plan is employer matching contribution. Any good financial advisor will tell you this is basically “free money,” and you should take advantage of it. Separately, you also have the option of tax-deferred growth, which means you can grow your investment without worrying about taxes until retirement. 

One of the biggest advantages of any 401(k) plan over an annuity is that you have a wider variety of investment options. This can include but is not limited to company stock, ETFs, mutual funds, and other options that allow you to create a customized portfolio based on your risk tolerance. 

As far as cons, a 401(k) has a contribution limit set in stone for 2024 and 2025. This limits your ability to save, as you cannot surpass the contribution ceiling. Another downside is that you may incur penalties for making early withdrawals before you turn 59.5 years of age. This could mean as much as 10% on top of any income taxes you would pay.

Lastly, 401(k) growth is hard to predict as it is solely based on the stock market’s volatility. Your accounts will rise and fall in the short term with hopeful long-term growth. 

Long-Term Retirement Strategy

With both a 401(k) and annuity offering long-term savings, the potential for tax-deferred growth, and beneficiary options, you often have to choose by using one or another. Ultimately, the choice comes down to your situation as well as your level of risk tolerance. 

Suppose you like various investment options, the benefits of an employer-matching contribution, and the potential for high returns. In that case, you should go with a 401(k) if you are okay with unknown income potential. 

On the other hand, if you would rather have a steady and guaranteed income stream during retirement and have fewer concerns over income growth, an annuity may be your best option. You should choose an annuity if you don’t want to worry about the stock market. 

Ultimately, annuities will offer you more peace of mind as they are less tied to market conditions, but with higher fees and less flexibility, you don’t have much control over what you are earning. Conversely, a 401(k) offers you significant growth potential you won’t get from an annuity but with far more risk. 

Can You Combine a 401(k) and Annuity? 

One of the potential options many people have but never consider is that you may be able to use money from your 401(k) account to purchase an annuity. A strategy is available to roll your 401(k) to a tax-free annuity and ensure you have a steady income stream during retirement. 

This idea would be advantageous if you have concerns about your money running out while retired. Having guaranteed income with an annuity ensures you will always have it as a source of earnings, which means you’ll have money to cover your expenses. As long as you are alive, the payments will keep coming in. 

While using 401(k) money to purchase an annuity can be beneficial, remember that you still have to consider any early withdrawal fees and that the return on annuities, while guaranteed, may be lower than overall stock market performance.

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