Although the appeal of having guaranteed income after
retirement is undeniable, there are actually a number of risks to consider
before rolling your 401(k) into an annuity. In addition to the sometimes hefty
fees incurred by annuitants, you risk losing part of your investment if you die
prematurely, as you may not be able to pass the remainder of the annuity on to
your beneficiaries.
Many insurance companies tout the tax benefits of annuities.
However, a traditional 401(k) is already tax-sheltered, and a delayed rollover
could cost you in taxes.
Extra Fees
The chief benefit of annuities is that they provide
guaranteed income. Although there are some important differences between the
income generated by fixed compared to variable annuities, the majority of
annuity investments are made by people looking to ensure that they are provided
for in later life. However, you are likely to incur some substantial expenses
just for the privilege of owning an annuity, in addition to your capital
investment.
The specific fees charged by your insurance company vary
with the type of investment you choose. Variable annuities tend to have higher
fees than their fixed counterparts because they require a more active, engaged
management style. Annuities that protect your principal or guarantee your
balance cannot decrease carry even higher fees, often around 2% to 3% annually.
These fees cover management and administrative expenses
incurred throughout the year. However, you likely pay an additional annual fee
to offset the risk the insurance company assumes in selling you an annuity,
such as the risk you will live longer than expected.
Other fees may be one-time up-front costs, such as a sales
fee to cover the commission of the person who sold you the annuity or a
contract fee. Although these expenses seem small individually, they can drain
your retirement funds over time because they reduce forever the amount of money
left in your account to invest.
If you decide an annuity is no longer the right investment
for your needs and want to withdraw your initial investment, you incur a
serious surrender charge. This charge typically starts at 7% and gradually
decreases over the first seven to 10 years of account ownership.
Risk of Loss
If you die before you use up your 401(k) savings, your named
beneficiary inherits the account just like any other asset. If you die before
you receive full benefits from your annuity, however, the insurance company may
end up keeping the remainder of your savings.
Many annuities offer the option of having the contract pay
over the course of your life and then transfer to your spouse if you die first.
This feature generally comes at an additional premium, so your savings may be
at risk if you do not read the fine print.
Tax Trade-Off
Many financial advisors recommend annuities because your
investment grows tax-deferred, meaning you pay no income tax on your gains
until they are withdrawn. However, if your investment capital is already in a
traditional 401(k) or individual retirement account (IRA), a rollover to an
annuity offers no additional tax benefits. Earnings on 401(k) funds are already
tax-deferred, as are your original contributions. As with an annuity, you do not
pay income tax on your contributions or interest until you withdraw those funds
after retirement.
Tight Time Limits
Another risk to consider when rolling over your 401(k) into
an annuity: the tax implications of the rollover itself. While the Internal
Revenue Service (IRS) allows for tax-free rollovers from qualified retirement
plans, you must complete the transaction within 60 days or risk forfeiting 20%
of your balance.
Any amount you do not roll over is taxable as ordinary
income, which can substantially increase your tax liability for the year.
Arranging for a direct rollover from trustee to trustee is the way to steer
clear of this risk.
The SECURE Act and Annuities in 401(k) Plans
A possible alternative to rolling your 401(k) into an
annuity is to see if your employer-sponsored retirement plan already includes
an annuity option. The Setting Every Community Up for Retirement Enhancement
(SECURE) Act eliminates many of the barriers that previously discouraged
employers from offering annuities as part of their retirement plan options.
For example, ERISA fiduciaries are now protected from being
held liable should an annuity carrier have financial problems that prevent it
from meeting its obligations to its 401(k) participants. Additionally, annuity
plans offered in a 401(k) are now portable. This means if the annuity plan is
discontinued as an investment option, participants can transfer their annuity
to another employer-sponsored retirement plan or IRA, thereby eliminating the
need to liquidate the annuity and pay surrender charges and fees.
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