Should Your 401(k) Be in an Annuity?

The big advantages are mostly for those close to retirement

Fact checked by Vikki Velasquez
Reviewed by Ebony Howard

Do you have a traditional 401(k) plan? If so, then you’re familiar with the advantages of saving for retirement with pretax dollars. You probably also know that within your 401(k), you have a choice of investments. Typically, you can invest your money in target-date funds, passively-managed index funds, and actively-managed mutual funds. Some plans allow you to purchase annuities, which are another option for funding retirement.

Annuities are not a common option in 401(k) plans, however. Even though including this option might improve workers’ retirement security, annuities are a more complicated offering than the typical fund offerings. The fees can be substantially higher, depending on the type of annuity. The choice of insurance provider also entails risk (annuities are sold by insurance companies, and some insurance companies are more financially sound than others). In short, plan sponsors increase their chances of being sued when they offer annuities.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which became law in December 2019, gives employers greater leeway to include annuities in their workplace-sponsored retirement plans. Under the law, plan sponsors face less risk of being sued if the insurer that they pick to make annuity payments goes bankrupt and can’t pay claims.

Key Takeaways

• People who feel uncomfortable with devising their own retirement income strategy might benefit from using a portion of their 401(k) to buy an annuity.
• Few 401(k) plans offer annuities, and few employees buy them.
• Just because your 401(k) plan has the option to buy an annuity doesn’t mean that the annuity is a good one or the right one for your situation.
• An immediate or deferred fixed annuity can provide a steady income for life. Optional features can leave principal and annuity payments to a spouse or other beneficiary.

Why Would You Want an Annuity in Your 401(k)?

One of the biggest concerns for workers and retirees is running out of money in retirement. Annuities are an appealing solution to this problem because they can provide a lifetime of guaranteed income, depending on what kind of annuity you buy. In an era when defined-benefit pensions have largely been replaced by defined-contribution plans, such as 401(k)s, the opportunity to create a sort of self-funded pension with an annuity may be reassuring to many retirees.

While 401(k) plan providers have found ways to make it easy for workers to save for retirement through automatic plan enrollment, matching contributions, and default investments, they have not made it easy for workers to turn their savings into a steady, enduring stream of retirement income. It is up to retirees to decide how to both draw down their assets and change their asset allocation throughout retirement. Many plans offer target-date funds that can simplify the process.

The Center for Retirement Research at Boston College published a study suggesting that buying an immediate life annuity would give a 65-year-old male the most income among the available options. The study’s authors make a strong case for traditional annuities by showing how annuitization is superior to investing with 3% returns, taking annual withdrawals based on remaining life expectancy, and taking required minimum distributions (RMDs). It would also prevent the retiree from running out of money.

How Much Monthly Income Could an Annuity Give You?

Let’s be clear about what not running out of money actually looks like. Let’s say the 65-year-old man lives in Massachussetts. If he buys a $100,000 single premium immediate annuity with payments beginning in February 2025, his monthly income for life is estimated at only $642, according to Schwab’s Income Annuity Estimator. That payment will never be adjusted for inflation, and his heirs won’t receive anything when he dies, even if he dies long before he breaks even.

He can make sure his annuity pays out for exactly 10 years. These 10 years are called a period certain. In this case, his monthly payment would be $1,017, and the annuity will pay out at least $122,040. And if he dies before the 10 years are up, his heirs would receive the funds.

Many retirees have spouses to consider. This man could instead buy a joint-life annuity with his $100,000. It would pay $561 per month for life as long as either he or his wife (also age 65) were alive.

^{Source: Charles Schwab}

By comparison, here are the payouts you might expect from having similar balances in an index fund. (Keep in mind that market fluctuations and the sequence of returns could change things significantly.)

^{Source: MyCalculators. com. Table assumes average annual growth of 6%, an inflation rate of 3%, and a drawdown to zero after 30 years. Monthly income is based on annual withdrawals at the beginning of each year.}

Corporate revenue and earnings should keep pace with inflation, so unlike a fixed annuity, we can expect the index fund’s returns to increase annually to account for inflation. (That said, some fixed annuities do offer inflation protection in exchange for receiving lower payments initially.) Keep in mind that when annuity rates are low because of a low-interest-rate environment—like the early 2020s—fixed annuity payouts will look especially disadvantageous compared to long-term stock market returns.

Also, keep in mind that your internal rate of return (IRR) from a fixed annuity depends on how long you live. The longer you live, the more valuable the annuity. A 65-year-old man might have a negative IRR in years one through 17, break even after 18 years, and reach an IRR of 2.68% if he lives to age 95. (That’s calculated with an annual rate of return calculator, with inputs of 30 years, an $100,000 initial investment, and $4,896 annual annuity payment, which is 12 times the $408 from the example above.) That’s still a lot lower than 6%.

Another way of looking at the difference between the returns of the annuity and the index fund in our example is that if you withdrew the same amount from the index fund as you would receive from an annuity each month, you would still have a substantial sum left in your index fund if you died in 30 years, but the annuity would become worthless.

Check Your Plan’s Fees

Plan sponsors have certain obligations to plan participants under the Employee Retirement Income Security Act (ERISA). So it would be natural to assume that if your plan sponsor offers an annuity within your 401(k), it’s been vetted as a solid choice. However, it’s unwise to blindly trust that your employer has made an ideal choice.

Why is that? As we’ve seen, employees have brought numerous lawsuits against 401(k) plan sponsors for excessive investment and administrative fees.

Further, the SECURE Act does not require plan sponsors to choose low-cost annuities. It only requires the cost to be reasonable. If the annuities offered within your 401(k) are not satisfactory, rolling over part of your 401(k) to an outside annuity is another option. Just make sure you wait until you’re 59 ½, or you’ll have to pay an early withdrawal penalty to the IRS.

Pros and Cons of Buying an Annuity Within Your 401(k)

All of this means that there are a number of factors to consider when thinking about whether it makes sense to hold an annuity in your 401(k).

Pros

Sharing his expertise with The Wall Street Journal, David Blanchett, head of research for Morningstar Investments, wrote about the advantages of buying an annuity within a 401(k).

Non-gendered pricing. One advantage of buying an annuity within your 401(k) if you’re female is that your gender won’t affect the price. Annuity prices reflect life expectancy, and outside of a 401(k), women can expect to pay more (that is, receive a lower monthly payout for the same principal amount) because they live longer on average. On the other hand, bought within a 401(k), this smoothed-out pricing means men might pay more.

Logical choice. People tend to hold most of their net worth in their retirement accounts and in their home equity. And you will always need cash on hand in case of an emergency. You may not have enough non-retirement funds to buy an annuity outside your 401(k). For these reasons, it becomes logical to tap a 401(k) to buy an annuity. It’s also logical to use the money you’ve specifically set aside for retirement, rather than some other pot of savings, to provide a retirement income stream.

Possibility for a higher payout. Annuity payments also might be higher within a 401(k), Blanchett writes, because insurers can save money on marketing when they have a large pool of potential customers supplied by an employer. But you shouldn’t assume that payments are better without seeing what outside annuities have to offer, he cautions.

Cons

Slower growth. If you were to buy a deferred annuity, where you wouldn’t start receiving an income stream until perhaps a decade or more after buying the annuity, your annuity principal would grow over that decade. You could expect to receive an interest rate similar to what a certificate of deposit (CD) would pay, which would be similar to the inflation rate. That is, your money will likely grow more slowly than it might if invested in stocks or exchange-traded funds (ETFs).

Hard to change your mind. Getting money out of an annuity while still in the accumulation phase is complicated and can entail surrender charges. The fewer years you’ve paid into the annuity, the larger the surrender charge may be. Also, once you’ve annuitized, or started receiving payments, your decision is usually irrevocable.

No additional tax benefit. Annuities have the same tax-deferral benefit that traditional (non-Roth) 401(k)s have. You don’t pay taxes on the growth in an annuity—or on the money in a traditional 401(k)—until you take the money out. Morningstar’s Blanchett suggested purchasing an annuity using the money in a taxable account if you have the funds. It doesn’t make sense to buy an annuity in an account where you already get the benefit of deferred taxes. However, many people don’t have the funds in a taxable account to buy an annuity.

Failure to at least break even. A concern that people have about buying annuities is dying before they’ve at least broken even with the principal they’ve put into the product. Money that you use to buy an annuity is money that you generally cannot leave to your spouse, children, or other heirs. But you can if you’re willing to pay more to obtain principal protection or period certain benefits.

Pros

• You may get a higher payout than from other annuities.

• Fees negotiated by your employer may be more reasonable.

• The annuity provider is likely to have been carefully vetted by your employer, which has fiduciary responsibility for the security of your plan.

• Women won’t pay more for the same coverage.

Cons

• Your ultimate payout may be much lower compared to investing in stocks or exchange-traded funds (ETFs) if you buy an annuity when interest rates are low.

• Putting already tax-deferred 401(k) funds into a tax-deferred annuity yields no additional benefit.

• Single-life annuities leave nothing to heirs. Protecting heirs means reducing monthly income.

• Men might pay more for the same coverage.

• No automatic inflation protection. (Riders that provide inflation protection reduce the initial payout.)

Types of Annuities Allowed in 401(k) Plans

A qualified longevity annuity contract (QLAC) is a type of advanced life deferred annuity funded with an investment from a qualified retirement plan, such as a 401(k) or an individual retirement account (IRA). You can use up to $145,000 of your retirement savings account to buy a QLAC.

The main benefit of a QLAC is a deferral of taxes that accompany required minimum distributions (RMDs). The QLAC’s value is not included in RMD calculations. It must begin paying out by age 85. A retiree or near-retiree might wish to buy a QLAC at age 70 before RMDs kick in at age 73 if they have plenty of retirement income from other sources. (RMDs used to kick in at age 72 before the passage of the SECURE 2.0 Act, but the new age is 73.)

The QLAC is not the only type of annuity that you may be able to purchase in your 401(k) plan. You may be able to buy other types, such as a simple fixed immediate annuity (shown in the first table earlier in this article), the far more complicated and expensive variable annuity, and the slightly less complicated and expensive indexed annuity.

Do Your Research

Make sure that the insurance company offering the annuity has strong financial strength ratings from credit rating agencies such as A.M. Best. Also, check how the annuity’s fees and payments compare to annuities that are outside your 401(k).

Who Should Use Their 401(k) to Buy an Annuity?

If you are retired and prefer to have steady, guaranteed income for life, then an annuity may be a good option. Annuity income may not be as high as income generated through investments. However, there is also no risk of losses nor interruptions in payments.

Is Annuity Income from a 401(k) Taxable?

Typically, yes. Traditional (non-Roth) 401(k) accounts are funded with pre-tax dollars and therefore have a deferred tax liability. That means that investment gains and income—including annuity income—would be taxed at your income tax bracket at the time.

If the annuity sits in a Roth 401(k) that is funded with after-tax dollars, however, it can generate tax-free income.

Where Can I Find Annuities to Put in a Retirement Account?

You can purchase an annuity or roll retirement assets into a qualified retirement annuity via an insurance company. Other financial firms like brokerages or banks may also offer annuity products.

The Bottom Line

Few 401(k) plans offer annuities today, and even when they do, workers usually don’t choose them. But that’s changing, as the SECURE Act demonstrates. That said, whether to buy an annuity within a 401(k) is a complicated decision that can have a big impact on your retirement. It’s highly personal, and what your co-worker is doing may not be the right choice for you. It’s important to have all the facts and compare your options so you can make the right decision.