Does an Annuity Belong in Your 401(k)?

Annuities can help you create additional income in retirement beyond of what you expect to get from your 401(k) or a similar tax-advantaged account. Thanks to the SECURE Act of 2019, purchasing an annuity from a 401(k) is now a possibility. But does an annuity in a 401(k) make sense for your financial situation? It’s an important question to ask as you save and invest for retirement. Here’s what you need to know about incorporating an annuity option into your workplace savings plan.

A financial advisor can help you plan for retirement and assess whether an annuity should be a part of your strategy. Speak with your financial advisor matches today.

What Is an Annuity?

An annuity is an insurance contract that you buy from a broker or insurance company. You pay either a single premium upfront or a series of premium payments toward the annuity. Then at a specified date, the company you purchased the annuity from pays you, either in a lump sum or as a series of payments.

Annuities can be difficult to understand and to purchase if you don’t know much about them. For example, annuities aren’t one-size-fits-all. You can have a deferred annuity, which begins paying money to you at a future date or an immediate annuity, which begins paying money to you typically within one year of purchasing it.

Annuities can also be fixed, variable or indexed, based on how the premiums you pay are invested. An indexed annuity, for example, may be invested in index funds or other mutual funds that are designed to mimic the performance of a specific stock market benchmark, such as the Nasdaq Composite or the S&P 500. A fixed annuity, on the other hand, earns a fixed rate of return and is generally a low-risk way to accumulate money for retirement. There are even fixed indexed annuities, as well.

SECURE Act’s Impact on 401(k) Annuities

The Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in December 2019 and it represents a major change to how employers approach workplace retirement plans. The law, which took effect Jan. 1, 2020, brought significant changes to retirement savings, including new rules for incorporating annuities within 401(k) plans.

The SECURE Act makes it easier for employers to offer annuities as part of their 401(k) plans by providing a legal safe harbor for plan sponsors. This safe harbor means employers are protected from liability when selecting an annuity provider, provided they meet specific requirements. The intent is to encourage more employers to make annuities available, giving employees options for stable income during retirement.

The SECURE Act could help remove some of the confusion surrounding annuities by leaving it up to 401(k) plan administrators to decide which annuity products to include. If a plan offers a simple income annuity, for example, you could choose to purchase it to generate guaranteed lifetime income once you retire, alongside any money you’re withdrawing from your 401(k), IRA or taxable investment accounts, as well as the money you’re getting from Social Security.

How Does a 401(k) Annuity Work?

When you choose an annuity within your 401(k), a portion of your contributions goes toward funding this contract, which guarantees income in retirement based on the annuity’s terms. Typically, you’ll have the option to select from different types of annuities, such as fixed or variable, each offering distinct payout structures.

The SECURE Act also allows for greater portability, so if your employer decides to remove an annuity option from the plan, you can transfer your annuity to an IRA or another 401(k) plan without surrender penalties. This new framework aims to make annuities a more practical and flexible retirement income solution within 401(k) plans, providing more options for steady income in retirement.

Pros of Purchasing an Annuity from Your 401(k)

The SECURE Act opened the door to investing in an annuity through your 401(k) or other workplace retirement plan, and there are some potentially good reasons to consider it.

For one thing, you may benefit from lower pricing by purchasing a 401(k) annuity. If plan administrators are able to secure institutional pricing for annuities inside the plan, that could translate to lower costs for you to own one. Paying less in fees is a good thing since fewer fees means you get to keep more of your money’s growth.

Annuities that are sold directly to consumers can have a number of fees, including mortality risk fees, commissions paid to the broker selling the annuity, surrender charges and early withdrawal fees. And of course, the underlying investments in the annuity will have their own fees. For example, if your annuity holds mutual funds, each fund would have an expense ratio.

Holding an annuity inside your 401(k) can also offer a measure of assurance about your retirement future if you haven’t contributed as much to the plan as you’d like or you got a late start on saving. Broadly speaking, annuities are designed to provide lifetime income and under the SECURE Act, plan administrators are required to choose annuities that guarantee income for life.

That means you’ll receive payments from the annuity until you pass away, with the potential to extend those benefits to your spouse or another beneficiary. If your nest egg is smaller than you’d planned or you’re unsure how much money you’ll receive from Social Security, an annuity could help you feel more confident about having enough income to retire.

Cons of Purchasing an Annuity from Your 401(k)

On the other hand, the SECURE Act doesn’t require plan administrators to choose the lowest-cost annuity option. That means it’s possible that investing in a 401(k) annuity could be just as expensive as purchasing one on your own. What’s also important to keep in mind is the reliability of the annuity company that a plan administrator chooses.

The SECURE Act imposes a fiduciary standard on plan administrators when it comes to choosing an annuity provider. That means plan administrators have to act in the best interests of plan contributors when choosing a company that offers simple lifetime income annuities. The wording of the act, however, essentially allows for the annuity provider to self-verify their financial status and stability. So it’s possible that even with the act in place, you could end up purchasing an annuity from a company that may run into financial trouble down the line, leaving them unable to make your annuity payments.

Finally, it’s important to consider whether a 401(k) annuity is a good choice for the long term if you think you’ll change employers at some point. Having an annuity inside your plan may affect your decision-making when it comes to deciding whether to roll over your plan to an IRA if you change jobs or transfer it to your new employer’s 401(k).

Bottom Line

Before passage of the SECURE Act annuities and 401(k)s were distinct, but the new law makes it possible to purchase annuities inside your employer-sponsored plan. Nevertheless, it’s important to do your homework first to make sure such a combination complements your retirement strategy.

Annuity Tips

If you’re considering an annuity, be sure to educate yourself on the basics of these products and the different types of annuities that are available. Take time to learn the types of fees you can expect with an annuity and how much annuities can pay out. The better you understand how they work and what they can do for you in retirement, the easier it becomes to decide whether purchasing one is the right move.
Also, consider speaking with a financial advisor about whether you should invest in an annuity inside your 401(k). Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.