Both 401k and annuities being instruments of saving for your retirement, knowing the differences between them is important. Annuities are generally offered by life insurance companies while 401k is a retirement plan offered by an employer to his employees in U.S. Annuity refers to an agreement that you have with an insurance company wherein you pay a specific amount every year to reap the benefits after a set period of time whether or not you are retired. In 401k, the employer withholds a percentage of the salary of the employee as a contribution to a fund to which he may also contribute. This fund attracts interest and the employee receives money every month after retirement.
401k
401k is a retirement benefit plan that is offered by an employer to his employees. If you opt for a 401k, you need to contribute a part of your salary to it, to which the employer may also contribute, and the fund grows till the time of your retirement. You are eligible for withdrawal only if you are at least 59 ½ years old and if the fund is at least 5 years old. You can contribute up to $4000 per annum to your 401k fund, and the tax is deferred until you start receiving monthly payments upon retirement. There is a 10% penalty imposed by the IRS if you withdraw the money before the age of 59 1/2. However, you can avail a loan from this fund.
Annuity
Unlike pension and 401k, annuity is a deal between an insurance company and you whereby you agree to pay a predetermined sum of money every year for a long period which may be 15-20 years, and the company agrees to pay back a set amount of money every month to you after the expiry of the term. There are both fixed annuities where the purchaser gets a predetermined amount of pay check after the accumulation period, and variable annuity, where this amount is linked to various securities and funds to earn a better rate of interest. Annuity is a tax deferred plan which implies that you do not pay any tax for the tie period of annuity, and tax cut is applied when you start receiving the monthly payment.
Difference between401k and Annuity
Despite being tools for future saving, there are sharp differences between annuities and 401k plans. The most glaring difference is the fact that you choose annuity as a financial product from an insurance company while 401k is a retirement plan offered by your employer.
One similarity between the two instruments is the nature of tax deferral, wherein the savings are exempt from tax, and you have to pay tax on the benefits upon your retirement like any other ordinary income. Annuities can be purchased by anyone who is an adult, irrespective of whether he is in job or doing his own business.
Another difference is in the rate of return. If you opt for a fixed annuity, you know the amount of your monthly pay check after the completion of the time period of accumulation. The returns are generally low, and you also need to see that the insurance company is solvent and has a good reputation or else you may lose your entire investment. This is not the case with a 401k, where you are assured that you will reap the benefits upon your retirement.