401K vs. Annuity – The Difference Between 401K and Annuity

Saving for retirement is very important during your working years and there are two main ways in which you can save the money that will let you sit back and relax in your senior years. These are 401k and annuities and because they are different from each other it is essential that you understand the features of each one. In the US a 401k is an retirement plan that an employer offers to the employees, while an annuity is an agreement that you make with a life insurance company.

Both of these retirement savings plans require that you pay premiums into the plan, but this is done in different ways. In an annuity you have to search for a life insurance policy and pay a set premium each year for a set number of years. In a 401k, the employer withholds a percentage of your salary and puts into the plan and if you wish you can also contribute an amount of your choosing. The money paid into the plan earns interest and when you retire you receive a monthly payment.

More about a 401k

A 401k is like a company pension plan. Each pay check an amount will be deducted and paid into this plan. You can elect to have an extra amount withheld and all the monies paid will earn interest. The amount of interest grows as the fund increases. You cannot start withdrawing any money from a 401k until you are 59.5 years of age and you must have paid into the plan for five years.

The IRS permits you to pay up to $4000 a year into a 401k and you don’t have to pay taxes on this money until you start taking a monthly payment when you retire. You can withdraw the money before you reach the age of 59.5, but if you do so the IRS imposes a 10% penalty.

More about an annuity

An annuity is an insurance policy that you take out on your own. It can be for any length of time, but the norm is 15 to 20 years. You pay a premium on a regular basis, whether it is monthly or annually, into this policy and at the end of the term the company will pay you back the money in monthly installments. You don’t pay any taxes on the money that you pay into an annuity, but the monthly payments are taxable once you start receiving them.

There are two types of annuities that you can choose from is this is your choice for retirement savings. You can select a set payment each month so that you know exactly how much you will receive or you can choose a variable payment. With the latter the amount you receive can vary from month to month because of market conditions.

Conclusion

Both annuities and 401k plans are ways to save for retirement. The main difference is that a 401k plan is offered by an employer but an annuity is a personal decision. Both are tax exempt as long as you are paying into them, but they are taxed when you start withdrawing the money. You do earn the best interest rates with a 401k because fixed annuities are usually at a lower rate and you would be running a risk by choosing a variable annuity in which the monthly payments could vary.