401(k)s and annuities are two of the most popular vehicles to accumulate assets for retirement. While they share a range of characteristics and features, 401(k)s and annuities function quite differently from one another, and each has its own distinct advantages and disadvantages. Your decision whether to invest in a 401(k), an annuity, or perhaps both will depend on your individual circumstances and retirement goals.

In this article, we will highlight the attributes of 401(k) and annuities, so you can better understand their differences and discern whether they are right for you.

What is a 401(k)?

A 401(k) is a company-sponsored retirement program which employees can choose to participate in. Typically, a regular deduction from the employee’s paycheck will be contributed towards their 401(k) account. These contributions are generally tax-free when you make them, the exception being a Roth 401(k) which is funded with after-tax money.

The funds in a 401(k) are invested vehicles such as mutual funds, stocks, bonds, exchange-traded funds and cash. Upon retiring, you can withdraw funds from the account to cover your retirement expenses. Taxes don’t apply to the money until you withdraw it.

What is an Annuity?

An annuity is a life insurance policy set up to work as an investment. Basically, annuities are contracts between you and an insurance company. You pay the insurance company either a large premium or a small amount. Insurance companies promise to pay you a certain amount each month in return for your coverage. These payments generally begin when you retire and continue until you die.

Major Differences Between 401(k)s and Annuities

A 401(k) retirement plan is only available to those employed by companies who offer  them. You cannot contribute to a 401(k) if your employer does not offer one. However, anyone can buy an annuity.

The fee structure is another major difference. 401(k) fees are usually quite easy to check. Just ask your plan administrator to explain any fees that have been charged to your account. Remember, depending on how your assets are invested, there may be “hidden” costs such as those charged by mutual funds. The fees associated with annuities can be difficult to calculate and are often much higher as they may include sales commissions, and there are often additional charges for benefit riders.

Another difference between annuities and 401(k) accounts is that you can borrow from your 401(k) but not from an annuity. Additionally, be aware of whether your annuity pays out as a static payment (payments remain unchanged over time) or a dynamic payment (which can increase over time) as static payments will not protect you against inflation.

There are also differences with inheritances. 401(k) plans can be passed on to heirs. In contrast, annuity payments stop when you (or your surviving spouse if the annuity accounts for them) pass away.

When is it Better to Choose: a 401(k) or an Annuity?

Both 401(k)s and annuities offer the opportunity for long-term savings, tax-deferred growth, and beneficiary options to transfer assets outside of probate.

It may be a good idea to contribute to a 401(k) if you want to save money for growth while still having access to it when needed. Conversely, investing in an annuity may be the wiser decision if you want to supplement your income for the rest of your life without worrying about market downturns. Annuities also offer the ability to cover the longest living spouse.

We recommend plugging each vehicle or product into your plan to see if it reduces your shortfall. Where to invest your retirement dollars is a critical decision that should be considered carefully, with the potential pros and cons weighed for your specific situation. The best thing you can do is research both types of investments thoroughly and have a financial advisor assist you when in doubt.