In financial planning, there are a variety of ways to direct your money, often based on specific goals and each with different tax implications.
You might put an emergency fund in an easy-to-access savings account at your local bank, where volatility is low. For mid-term needs such as car purchases, home renovation, or travel (any bigger expenses you’re anticipating over the next five to ten years) you might choose to invest in a non-qualified brokerage account. Lastly, for long-term goals, you might invest in retirement accounts that defer, or even avoid, taxation if done correctly. That last part is of course key.
Bear in mind that a 401(k) is an employer-sponsored retirement plan. These plans exist because Uncle Sam views retirement savings as important for the American public, especially in a generation where pensions have gone the way of the buffalo (you don’t see many of them anymore).
To better create retirement savings, these qualified plans come with a big tax advantage: deferral. The money you put into a traditional 401(k) is tax-deductible, which means your tax payments are deferred until you pull them out during retirement. This allows the funds to grow unencumbered.
At the beginning of 2020, the SECURE Act created more options for including annuities inside your 401(k) plan. One benefit that annuities provide retirees, which hadn’t previously existed as part of a 401(k), is a guaranteed income stream. This brings us back to the main question—should you incorporate one of these options into your 401(k)? The short answer is not unless you need guaranteed income soon.
Here’s why: If you were to position some of your 401(k) money in an annuity within the employer plan, you wouldn’t be adding any new tax benefits. You would, however, be adding new fees and expenses, which would be embedded into the plan.
While the original money in the 401(k) would continue growing tax-deferred, the new money inside the annuity would add mortality costs and expenses (remember that annuities are insurance products by design), costs for any associated riders, as well as costs for the underlying investments inside the annuity.
In contrast, money invested in the plan’s portfolio of equities and bonds will typically have fewer associated costs. Historically, these diversified portfolios have achieved a better rate of return than annuities. Of course, time horizon is key. You want to make sure that your asset allocation is appropriate for how soon you need to start withdrawing from your portfolio.
Your 401(k) is already a tax-advantaged retirement account. You receive no added benefits for using 401(k) dollars to purchase an annuity for a long period of time—other than to receive income payments. So typically, the best use for an annuity is to “turn on” the income stream soon after purchasing it, instead of using it as an accumulation vehicle.
Even if the cost associated with an annuity is cheaper as part of your 401(k), you’ll typically have more options after rolling your 401(k) into an IRA. As always, if you’re unsure about what makes sense for your situation, reach out to your adviser.