401(k) plans have allowed annuities for several decades, but recent regulatory changes have made buying an annuity in a 401(k) a hot topic.
Annuitizing your 401(k) account can create a more pension-like retirement plan with fixed monthly payments. Obviously, this type of “guaranteed” monthly income is highly desirable for some people.
But please, consider the fees and risks associated with annuities before you purchase one. Plus, holding an annuity inside a tax-advantaged retirement account—like a 401K)—might not be the best alternative.
Tax deferred growth is a big advantage of buying an annuity. Given stand-alone annuities already provide tax deferred growth, owning one inside a retirement account—like a 401(k)—can be redundant. A bit belt and suspenders.
- History of Annuities in 401(k) Accounts
- What is an Annuity
- Different Types of Annuities
- Annuities in IRA and 401(k)
- Benefits of an Annuity in 401(k)
- Drawbacks of Annuitizing within a 401(k)
- Are Annuity Payments Really Guaranteed?
- Considerations Before Buying
- Tech Companies with Annuities as 401(k) Investment Option
- Companies Offering Low-cost Annuities
History of Annuities in 401(k) Accounts
The regulations allowing annuities in IRA and 401(k) accounts have evolved over time. The original regulations, which were put in place in the 1970s, did not allow annuities to be held in these types of accounts.
However, people wanted this option. Annuities offer a “guaranteed” income stream in retirement, which can appeal to people who fear outliving their savings.
In response, the regulations were gradually relaxed to allow annuities to be held in IRAs and 401(k) accounts. The most significant changes came in the following years:
- 1982: The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) allowed annuities to be held in IRAs, but only if the annuity was purchased with after-tax money.
- 1997: The Taxpayer Relief Act of 1997 (TRA) allowed annuities to be held in 401(k) plans, but only if the annuity was purchased with after-tax money.
- 2006: The Pension Protection Act of 2006 (PPA) allowed annuities to be held in IRAs and 401(k) plans, regardless of whether the annuity was purchased with after-tax money.
- 2019: The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 further relaxed the regulations by allowing employers to offer annuities as an investment option in their 401(k) plans.
It is important to carefully consider the pros and cons of annuities before making a decision to purchase one.
What is an Annuity?
An annuity is a financial product that provides a series of payments made at regular intervals, typically monthly, quarterly, or annually, in exchange for a lump sum payment or a series of contributions.
People often use annuities to plan for retirement, as they can provide a guaranteed income stream for a specified period or for the rest of their lives.
There are several key components of annuities:
Principal: This is the initial lump sum of money that you contribute to the annuity. It can be a single payment or a series of contributions over time.
Payout Period: Annuities are structured to pay out over a specific period or for the lifetime of the annuitant (the person receiving the annuity payments). The payout period can vary depending on the type of annuity and the contract terms.
Payout Options: Annuity contracts offer various payout options, including:
- Life Annuity: Payments are made for the lifetime of the annuitant.
- Joint and Survivor Annuity: Payments continue for the lifetime of the annuitant and, if applicable, a surviving spouse or beneficiary.
- Period Certain: Payments are made for a specific period (e.g., 10, 20 years) regardless of the annuitant’s lifespan.
Different Types of Annuities
There are different types of annuities, including fixed annuities, variable annuities, and indexed annuities. Each type has its own characteristics and features.
Fixed Annuities: These offer a guaranteed interest rate for a predetermined period. The payments from fixed annuities are generally stable and not subject to market fluctuations.
Variable Annuities: With variable annuities, the annuitant can invest in a selection of sub-accounts that are similar to mutual funds. The payments from variable annuities can fluctuate based on the performance of the underlying investments and are subject to market risk.
Indexed Annuities: These annuities are linked to the performance of a specific stock market index. While they offer the potential for higher returns than fixed annuities, they often come with a minimum guaranteed interest rate.
Annuities in IRA and 401(k) Accounts
IRAs: It is possible to purchase annuities within an Individual Retirement Account (IRA). This can provide a source of guaranteed income in retirement. Contributions made to a traditional IRA are typically tax-deductible, while Roth IRA contributions are made with after-tax dollars, potentially allowing for tax-free withdrawals in retirement.
401(k)s: Some employer-sponsored 401(k) plans may offer annuity options. However, these options can be less common in 401(k)s compared to IRAs. Employers may allow you to convert a portion of your 401(k) balance into an annuity at retirement. The rules governing 401(k) annuities can vary, so it’s essential to check with your plan administrator.
Benefits of an Annuity in 401(k)
There are many pros to annuitizing your retirement savings. For most people, the certainty of a monthly payment is the biggest advantage. Benefits include:
Guaranteed Income: Annuities can provide a predictable stream of income in retirement, which can be valuable for covering essential expenses.
Risk Mitigation: Fixed annuities offer protection against market volatility, making them a suitable option for risk-averse individuals who want to ensure a stable income in retirement.
Longevity Protection: Annuities with lifetime income options can help protect against the risk of outliving your savings. You’ll receive payments for as long as you live.
Tax Deferral: Like any investment within your 401(k), you can continue to defer taxes on the funds within the annuity until you start receiving payments.
The tax deferral benefit can be considered both a pro and a con. You don’t need to hold an annuity inside a 401(k) account to get the benefit of tax deferral. Hence, if you have money outside a retirement account, it may be better to purchase an annuity with those funds.
Drawbacks of Annuitizing within a 401(k)
Traditionally, one of the biggest disadvantages of annuities is high fees. Insurance agents sell most annuities on commission. This commission structure leads to high fees and expenses.
With annuities now allowed as an investment option within 401(k) plans, there is the potential for lower cost annuities. Consult with your plan administrator to understand the fees for your particular investment options.
In general, cons of buying an annuity with a 401(k) include:
Loss of Liquidity: When you purchase an annuity, you typically give up access to the lump sum invested, which can limit your future flexibility.
Fees and Expenses: Annuities often come with various fees and charges, including management fees, mortality and expense charges, and surrender charges if you want to withdraw your funds early.
Inflexibility: Once you start receiving annuity payments, it’s challenging to adjust or change the terms of the contract, so you may be locked into a particular payout structure.
Inflation Risk: Fixed annuities do not typically adjust for inflation, meaning that the purchasing power of your income may decrease over time.
Low Interest Rates: In a low-interest-rate environment, the income generated by fixed annuities may be less attractive. (The recent increase in interest rates should make annuities more attractive.)
Complexity: Annuities can be complex, and it can be difficult to understand all the terms and conditions.
Redundant Tax Deferral: Annuities already let you defer taxes. Hence, it is not necessary to hold them inside a 401(k) to get the tax benefit.
Are Annuity Payments Really Guaranteed?
Annuities are insurance products. The company selling the annuity is guaranteeing the payments. Hence, the “guarantee” of life-time payments is dependent on the insurance company staying in business. Although there are state-level guarantee associations that step-in and back failed insurance companies.
Annuities are contracts, and the financial stability of the insurance company issuing the annuity is critical because it determines the insurer’s ability to fulfill its obligations, including making future annuity payments. Here are some points to consider regarding this risk:
State Guaranty: In the United States, each state has a guaranty association that provides a safety net for annuity holders in the event that an insurance company becomes insolvent or goes bankrupt. These associations typically provide protection up to certain limits, which vary by state. However, the protection may not cover the full value of the annuity contract, especially if it exceeds the state’s limits.
Credit Ratings: Insurance companies are typically assigned credit ratings by independent rating agencies such as Standard & Poor’s, Moody’s, and A.M. Best. These ratings provide an assessment of the insurer’s financial strength and creditworthiness.
Diversify Annuity Providers: Consider diversifying your annuity investments across multiple insurance companies. This can help spread the risk of a single insurer’s financial difficulties.
Understand Surrender Charges: Be aware of any surrender charges or penalties associated with your annuity contract. In the event of financial difficulties, surrendering the annuity could result in significant penalties.
It’s important to note that the vast majority of insurance companies are financially stable and well-regulated. However, as with any financial decision, there is a level of risk involved. By doing your due diligence, diversifying your investments, and understanding the protections available in your state, you can minimize the risk associated with the potential bankruptcy of the insurance company that issues your annuity.
Considerations Before Buying
Before buying an annuity within your 401(k), consider the following:
Assess Your Needs: Determine if you have a genuine need for guaranteed income in retirement. Consider your other sources of retirement income, such as Social Security, pensions, and other investments.
Buy Outside a Tax-Advantaged Account: Do you have other funds you could use to buy an annuity? You may be better off owning an annuity outside of your 401(k) or IRA account.
Compare Options: Shop around and compare different annuity products and providers to find one that best aligns with your goals and offers competitive fees and terms. Understand what is allowed by your 401(k) plan sponsor.
Seek Professional Advice: Consult with a financial advisor or retirement specialist who can provide personalized guidance based on your financial situation and retirement goals. (Allows a good idea).
Review Your Plan Options: Understand the annuity options available within your 401(k) plan, as they can vary. Ensure that you fully comprehend the terms and any restrictions.
Consider a Partial Annuity: You don’t have to annuitize your entire 401(k) balance. You can opt for a partial annuity to retain some liquidity while securing guaranteed income for part of your retirement savings.
Tech Companies with Annuities as 401(k) Investment Option
Large tech companies, like other employers, may offer annuities as an investment option within their 401(k) plans. However, the availability of annuities as an investment option can vary from one company to another, and it’s subject to change over time.
Some of the well-known tech companies that offer annuities within their 401(k) plans include:
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Click here for details on 401(k) plan investment options for a number of large U.S. companies.
Please note that the availability of annuities and the specific annuity products offered within these companies’ 401(k) plans may change over time. Employers may periodically review and modify the investment options they provide based on factors like employee preferences, regulatory changes, and market conditions.
If you are an employee of a specific tech company, it’s important to review the details of their retirement plan documents and speak with your HR department to understand the current investment options, including annuities, within the 401(k) plan and how they may fit into your overall retirement strategy.
Companies Offering Low-cost Annuities
A number of companies offer access to low-cost annuities, often referred to as “no-load” or “low-commission” annuities. These annuities are designed to minimize or eliminate the upfront commissions and fees typically associated with annuity products.
Your 401(k) plan many only offer annuities from specific providers. You will need to consult with your plan provider about the annuity options available.
Some companies known for offering low-cost or no-commission annuities in the past (not necessarily inside 401(k) plans) include:
TIAA (Teachers Insurance and Annuity Association): TIAA is known for its annuity products, primarily serving educators and nonprofit organizations. They offer annuities with a focus on competitive fees and expenses.
USAA: USAA serves military personnel and their families and offers a range of financial products, including annuities. They may have low-cost annuity options available.
Fidelity: Fidelity is another reputable financial services company that provides a range of annuity options, including low-cost annuities designed to reduce commissions and fees.
Direct Purchase from Insurance Companies: Some insurance companies allow individuals to purchase annuities directly, which can reduce or eliminate commissions. You can inquire with specific insurance companies to explore this option.
It’s crucial to thoroughly review the terms and conditions of any annuity you’re considering, as annuity contracts can be complex.
Before purchasing any annuity, it’s advisable to consult with a financial advisor who can assess your specific financial goals and needs and help you select an annuity that aligns with your objectives while considering costs and features. Additionally, always verify the current offerings and fees with the insurance companies or financial institutions directly to ensure you have the most up-to-date information.
