Choosing the right way to save for retirement based on your personal needs is easier said than done. There are many options available, with annuities and 401(k) plans being some of the most prominent. While these two popular retirement savings vehicles are similar in some ways, they also have important differences, as well as times you can best use them. Below, we detail what should make or break your annuity vs. 401(k) decision. If you have questions about your specific situation, consider working with a financial advisor.
What Is a 401(k)?
A 401(k) is a tax-deferred retirement account you can often get through your employer. You contribute money to it, often as a regular deduction from your paycheck. You don’t have to pay taxes on earnings contributed to a traditional 401(k) at the time you make them. Roth 401(k)s, however, are funded with after-tax money.
The money in your 401(k) is invested in mutual funds, exchange-traded funds (ETFs) or other investments of your choosing. When it comes time to retire, you can withdraw funds from the account to cover your expenses. You don’t have to pay taxes on the money until you withdraw it. The funds in a Roth 401(k) are, again, exempt, as you’ve already paid taxes on your contributions.
What Is an Annuity?
An annuity is a financial product offered by life insurance companies. It functions as both an insurance policy and an investment. In simple terms, it’s a contract where you pay the insurance company either a lump sum or regular premiums, and in return, they agree to provide you with periodic payments, typically starting at retirement and continuing for the rest of your life.
You can fund an annuity with pretax money, such as through a 401(k), or with after-tax dollars. If you use after-tax money, the earnings from the annuity are taxable when withdrawn, but the initial amount you paid is not, as taxes were already applied at the time of contribution (similar to a Roth contribution). On the other hand, if the annuity is funded with pretax money, both the original contribution and the earnings are taxable upon withdrawal.
Major Differences Between an Annuity vs. 401(k)
While anybody can buy an annuity, only people whose employers have 401(k) plans can contribute to one. If your employer doesn’t have a 401(k) program, you cannot contribute to one. Anyone who’s self-employed, however, can set up their own 401(k).
Fees are another major differentiator. It’s typically quite easy to check the fees you’re paying for your 401(k). To do this, simply ask your plan administrator for an explanation of any fees charged to your account. Annuity fees are much harder to figure out, and are often significantly higher. In particular, you may pay steep sales commission fees for an annuity, benefit rider fees and more.
If you withdraw funds from your 401(k) before age 59.5, you may have to pay a 10% early withdrawal penalty in addition to the income tax due on the amount you withdrew. Annuities have their own early withdrawal fees, as well as annuity surrender fees. Annuity surrender fees are reduced as time goes by, meaning they’ll usually disappear after five years.
Another way annuities and 401(k) accounts differ is that you can borrow from your 401(k), but you can’t borrow from an annuity. Plus, most annuities provide unchanging regular payments, which means you won’t have inflation protection.
Inheritance is another point of discrepancy. Heirs can inherit your 401(k), while annuity payments typically cease with your death. Some annuities, however, allow you to pay more to purchase an annuity with a death benefit that will, like a regular life insurance policy, pay money to designated beneficiaries.
Making Withdrawals From Annuities and 401(k)s
Another big difference is that an annuity offers a guaranteed payment for as long as you live. That means, at least with most annuities, you won’t run out of money. A 401(k), on the other hand, can only give you as much money as you have deposited into it, plus the investment earnings.
If the market goes down, annuity payments keep coming. The same can’t be said of a 401(k), however, which is subject to market cycles. This also means if your 401(k) investment choices do well, you could have more money. With an annuity, you don’t benefit if the market is up, unless you take your chances with a variable annuity.
There are also limits on the amount you can contribute to a 401(k). For the 2025 tax year, the contribution limit amount is $23,500. This typically increases annually to account for inflation, and is up from $23,000 for the 2024 tax year.
If you’re 50 or older, you can put in another $7,500 as a “catch-up contribution” for both tax years 2024 and 2025. If you’re in the 60 to 63 age range, however, that catch-up contribution is increased to $11,250 instead of $7,500 for tax year 2025, thanks to a change made in the SECURE 2.0 Act.
Your employer may match all or part of your contributions, as well, which will further increase the amount going into your 401(k).
With annuities, there are no such limits, so some people buy them with one-time payments of sometimes $1 million or more. If you’ve maxed out your 401(k) contribution and want to sock away more, an annuity will let you do that.
When Should You Choose an Annuity or a 401(k)?
While both annuities and 401(k)s can offer long-term savings, tax-deferred growth and beneficiary options allowing you to pass down assets outside of the probate process, depending on your financial situation, a financial advisor might still recommend investing in an annuity later in life, especially if you’re still employed and haven’t maxed out your 401(k).
One option is using part of your 401(k) to buy an annuity. Some financial experts say that combining an annuity with a 401(k) could be an effective strategy to add a guaranteed income stream to your retirement. This option could help protect retirees from market downturns and deliver a regular paycheck in addition to Social Security income.
A recent study also says that annuities could be a good option for retirement as you shift assets away from stocks: “We find strong evidence that households holding more of their wealth in guaranteed income spend significantly more each year than retirees who hold a greater share of their wealth in investments.”
On the other hand, an annuity could fall short of your retirement goals as inflation could erode the value of your payments. For comparison, a Goldman Sachs report points out that stock market investments historically have averaged 10-year returns of 9.2% over the past 140 years.
In either case, whether you invest in an annuity, a 401(k) or combine both in your retirement strategy, consulting a financial advisor could help you assess the benefits and risks for your individual retirement needs.
Bottom Line
Choosing between an annuity and investing in a 401(k) is going to depend on a number of factors, from how much you can save to how much you need to earn during your retirement years. If you go through the pros and cons of each and still aren’t sure, consider working with a professional financial advisor to help you decide the best path forward to the retirement of your dreams.
Tips to Plan for Your Retirement
- 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.
- During the retirement planning process, it’s important to think about the retirement tax laws of the state you want to retire in. By minimizing your retirement tax burden, you can maximize the value of your savings in retirement.
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