Annuity vs 401k

Complete Guide to the Differences Between Annuities and 401(k) Retirement Accounts

Annuities and 401(k)s are both investment vehicles frequently used for retirement planning purposes. They are both designed to accumulate and build up retirement funds progressively through the money deposited by the holder and the subsequent investment of such funds, yet they are different in certain aspects.

Throughout this article we will disclose the various similarities, differences, and unique aspects of annuities and 401(k) to give the holder an overview on how they work.

What is an Annuity?

An annuity is often issued by an insurance company and they are commonly structured as a two-phase scheme. First, there’s an accumulation phase during which the holder of the annuity makes periodical deposits to the account to build up his retirement funds. This money is invested by the insurance company and the insurer commonly guarantees a minimum return rate per year.

After the annuity holder has reached a certain age, or under certain other circumstances, the annuity will enter a new stage known as the distribution phase. At this point, the amount of money that was accumulated during the accumulation stage will be distributed in a set of consecutive periodical installment paid out to the holder to cover his living expenses during his retirement.

In some cases, the insurer may also offer to pay a lump sum once the accumulation phase has ended and holder can pick between both alternatives depending on their individual preference.


What is a 401k?

A 401(k) is a retirement account offered by employers to help employees in saving money for their retirement. 401(k)s accounts work as a brokerage account, even though they have some unique characteristics that differentiate them from regular brokerage accounts.

The deposits made towards a 401(k) are typically deducted from the employee’s paycheck and employers also make a regular contribution to the account to assists employees in building up their retirement fund.

These funds are usually invested by a pension fund, by another professional investment firm, or they could also be invested by the holder individually, which is not advisable in most cases.

Once holders have passed the minimum retirement age, they can start withdrawing money from their 401(k) to pay for their living expenses without incurring any penalties by doing so. In contrast, if money is withdrawn before this age, the holder will have to pay a penalty that ranges from 5% to 10% of the withdrawn funds.

Key Takeaways

Income Structure: An annuity provides a guaranteed stream of income for a specified term or for life, offering predictable financial stability, whereas a 401(k) plan is a retirement savings account that allows for flexible withdrawals based on the account balance and market performance.

Investment Control and Options: With a 401(k), participants have control over their investment choices among the options provided by the plan, affecting the account’s growth potential. In contrast, an annuity’s returns and payouts are typically determined by the terms set at purchase, offering less control but more predictability.

Tax Treatment: Contributions to a 401(k) can be made pre-tax, reducing taxable income and allowing investments to grow tax-deferred until withdrawal. Annuities purchased with after-tax dollars offer tax-deferred growth, but the tax treatment of payouts depends on whether the annuity was purchased with pre-tax or after-tax funds and the type of annuity.

Key Differences Between 401k and Annuities

There are many differences between 401k accounts and annuities. Let’s examine the most important differences.

Purpose of each

The purpose of both 401(k)s and annuities is to provide the funds required to cover the living expenses of individuals once they have retired. In this sense, both financial vehicles have a stage during which these funds are saved and invested and a subsequent stage when the funds are disbursed and used.

Tax differences

One of the main advantages of 401(k)s vs. annuities is that monthly contributions on the former can be deducted, which means that taxes on these contributions are deferred and the same applies to any gains made on these funds. In contrast, contributions made towards an annuity are not tax deductible.

Finally, once the distribution of the funds starts the money received from both annuities and 401(k)s is taxed as ordinary income.


Early withdrawals are permitted in both annuities and 401(k)s but they are penalized. For 401(k) holders, any withdrawal made before the account holder reaches the minimum retirement age is penalized by a 10% tax on the amount withdrawn.

For annuities, the penalties vary and tend to be smaller compared to those applicable to 401(k)s. For example, most annuities apply penalties only during the early stage of the policy, for example, only to withdrawals made during the first 5 years.


Since most annuities are issued by insurance companies, they tend to offer holders the benefit of a life insurance policy attached to the annuity contract. This is a beneficial aspect of annuities as in the event of the death of the annuity holder the survivors will be entitled to receive certain compensation to cover their living expenses.

Since 401(k)s are essentially a brokerage account set by an employer, they don’t usually offer this kind of benefit.


One of the benefits of annuities is that the holder can make as many contributions as he wants, since there’s no limit to the amount that can be deposited into the account. 401(k)s, on the other hand, have a contribution limit of $19,000 per year and the limit goes up to $25,000 once the account holder is 50 years old.

The contributions on a 401(k) are tax deductible while those made towards an annuity are not.

Different Types

There’s only one type of 401(k)s but there are fixed and variable annuities. Fixed annuities offer a fixed annual rate of return on the funds invested towards the account while variable annuities generate different returns every year based on the market’s fluctuations.


Most annuities don’t offer the possibility of taking out a loan by using the funds invested as collateral, while 401(k) do allow the holder to borrow up to $50,000 on the amount they have saved.

Annuity and 401k Examples

Peter is a 33-year old business consultant who has been actively employed for 6 years now. During that time, he has built a 401(k) account consisting of both individual and employer contributions and so far the account has a balance of a little more than $65,000.

Nevertheless, Peter’s income is now higher than back when he started working and he has already maxed out the contributions he can make per year on the 401(k) and, therefore, he is contemplating the idea of setting up an annuity to complement his retirement savings.

This annuity is issued by Ultimate Financial Solutions LLC, an insurance company that offers a 6% fixed annuity with a minimum annual contribution of $5,000. After Peter reaches the minimum retirement age, he would be entitled to receive a certain number of periodical payments from this annuity along with the funds he decides to pull out of his 401(k).

Bottom Line

Annuities and 401(k) are both retirement products that share certain similarities and differences. They are both useful for retirement planning purposes but 401(k)s tend to be more beneficial as they offer certain tax benefits that annuities do not offer.

Frequently Asked Questions

How do annuities and 401(k) plans differ in terms of payout options?

Annuities offer guaranteed income streams for a set period or for life, providing financial security, whereas 401(k) plans allow for more flexible withdrawals that depend on the account balance and individual needs.

What are the tax benefits of investing in an annuity versus a 401(k) plan?

401(k) contributions are made pre-tax, reducing current taxable income and allowing for tax-deferred growth, while annuities purchased with after-tax money grow tax-deferred, and the tax treatment of withdrawals depends on the annuity type and funding source.

Can I control my investment choices with an annuity as I can with a 401(k)?

In a 401(k), you typically have the ability to choose from a range of investment options offered by the plan, providing some control over your investment strategy, whereas with an annuity, your investment returns and risk are managed by the insurance company based on the terms of the contract.

What role do annuities and 401(k)s play in retirement planning?

401(k) plans are designed to accumulate savings for retirement, offering potential for growth through investments, while annuities are often used to convert part of your retirement savings into a steady income stream, helping to manage the risk of outliving your savings.

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