The option to roll over a 401(k) into an annuity sounds like a good idea to some. However, there are risks to consider. For one thing, many annuities do not allow funds remaining in the account to go to beneficiaries after the owner dies. The money goes to the insurance company. There are also fees that need to be evaluated carefully.
Investopedia’s recent article asks “What Are the Risks of Rolling My 401(k) Into an Annuity?” The article says many insurance companies advertise the tax benefits of annuities, but a traditional 401(k) is already tax sheltered. A delayed rollover could mean more taxes.
Extra Fees. The big benefit of annuities is that they give you guaranteed income. However, there are some important differences between the income generated by fixed compared to variable annuities. Most annuity investments are made by people looking to ensure that they are provided for in later life. However, you’re likely to see some major expenses if you own an annuity, in addition to your capital investment. The types of fees from your insurance company will vary, depending on the type of investment you select.
Variable annuities usually have higher fees than fixed annuities, because they require a more active, engaged management style. Annuities that protect your principal or guarantee your balance can’t decrease, but have even higher fees. There also may be one-time up-front costs, like a sales commission or a contract fee.
If you decide to withdraw your initial investment early, you’ll be hit with a big surrender charge, typically at 7%-10% and gradually decreasing over the first seven to ten years of account ownership.
Risk of Loss. If you pass away before you use up your 401(k) savings, your named beneficiary will inherit the account. However, if you die before you get the full benefits from your annuity, the insurance company may keep the rest of your savings. Many annuities have the option of having the contract pay over the course of your life and then transfer to your spouse if you die first. Of course, there may be a fee for this. Ask questions and read the fine print.
Tax Trade-Offs. A financial advisor may recommend annuities, because your investment grows tax deferred. That means you pay no income tax on your gains, until they’re withdrawn. However, if your investment capital is already in a traditional 401(k) or IRA account, a rollover to an annuity gives you no additional tax benefits. Earnings on 401(k) funds are already tax deferred, just like your original contributions. As with an annuity, you don’t pay income tax on your contributions or interest until you withdraw those funds after you retire.
Time Limits. If you are considering rolling over your 401(k) into an annuity, you need to make a careful analysis of the tax implications. The IRS allows you to do a tax-free rollover into the annuity from a qualified plan, but it has to happen within 60 days, or you could lose as much as 20% of the balance. What you don’t roll over, gets taxed at ordinary income levels. The best way to do this without increasing your tax liability for the year, is to do a trustee-to-trustee direct rollover.
This can be a tricky transaction. It is best to do it only with the advice and help of a trusted financial advisor.
Reference: Investopedia (July 15, 2019) “What Are the Risks of Rolling My 401(k) Into an Annuity?”