What Are the Risks of Rolling My 401(k) Into an Annuity?

It’s guaranteed income, but understand what it will cost you

Fact checked by Katrina MunichielloReviewed by Thomas J. CatalanoFact checked by Katrina MunichielloReviewed by Thomas J. Catalano

Although the appeal of having guaranteed income after retirement is undeniable, there are a number of risks to consider before rolling your 401(k) into an annuity. In addition to paying fees, 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.

Key Takeaways

• Annuities can come with a host of fees and charges that reduce your funds significantly.
• Some annuities cannot be passed on to a beneficiary, which means any money left in them when you die goes to the insurance company.
• 401(k) funds are already tax-deferred, so there is no tax advantage to be gained by rolling them over into an annuity.

Extra Fees

The chief benefit of annuities is that they can 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 later in 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 that 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’ll 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 might seem small individually, they can drain your retirement funds over time because they forever reduce 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 may incur a serious surrender charge. This charge can start at 15% (or even more) and gradually decreases over the first 10 years or so of account ownership.

Important

An annuity’s guarantees are only as good as the financial strength of the insurer issuing it. Always check the insurance company’s financial strength ratings with Standard & Poor’s and AM Best before you buy an annuity.

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 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.

Advisor Insight

Adam Harding, CFP®
Adam Harding, CFP, advisor/owner, Harding Investments & Planning, Tempe, Arizona

There are a multitude of risks to rolling a 401(k) into an annuity. An important one to consider is that with an annuity you are limited to the investment options within the annuity, or, in the case of a fixed annuity, interest rates are historically low and your guaranteed payout is tied in some manner to current interest rates. You will also have an inflexible monthly income.

The reality of retirement is that some months are expensive and others are not. If you had a period of heightened expenses (such as paying for long-term care), you may not be able to increase your income from the annuity.

There are situations in which annuities are good for investors, but I have never recommended that anyone roll qualified assets into an annuity. It’s important to do your research and seek multiple opinions.

Alternative Options

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.

What Types of Annuities Are There?

There are a variety of annuities. Common types of annuities include fixed, variable, and indexed annuities.

What Is a Surrender Charge?

Annuity contracts are issued for a specified investment term. The insurer issuing the annuity charges a surrender fee if you withdraw funds during the annuity’s accumulation phase—in other words, before the investment term ends.

Do 401(k)s Offer Annuities?

Annuities are not common options in 401(k) plans. Annuities are more complicated than the investment options (typically mutual funds) offered in most 401(k)s.

The Bottom Line

When deciding whether to roll your 401(k) into an annuity, you have to balance a guaranteed income against the risk of your estate losing funds should you die prematurely, plus the fees you have to pay for having an annuity. Also check whether your employer-sponsored retirement plan already has an annuity option.

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