Risks of Converting Your 401(k) to an Annuity: Key Considerations

While annuities can provide guaranteed income after retirement, they also come with several potential risks that should be carefully considered before rolling over a 401(k). Fees, the possibility of losing your investment if you die prematurely, and limited ability to pass funds to beneficiaries can all reduce their appeal.

Additionally, because a traditional 401(k) is already tax-deferred, rolling it into an annuity offers no extra tax benefit and may even create unexpected tax costs. Before making the switch, it's important to review the alternative options available within your employer-sponsored plan.

Understanding Annuity Costs and 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.

Potential Financial Losses From Annuities

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 Implications of Rolling Over Your 401(k)

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.

Time Constraints and Deadlines for Rollovers

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.

Exploring Alternatives to Annuities

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.

The Bottom Line

When deciding whether to roll your 401(k) into an annuity, weigh the guaranteed income against the main risks, such as high or variable fees, lack of added tax benefits, and the potential loss of funds if you die prematurely.

Be mindful of rollover time limits and the financial stability of the annuity provider before committing. It's also worth checking whether your employer-sponsored plan already offers an annuity option, which may provide similar benefits with fewer costs or complications.