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401k Rollover into Annuity

Should I roll over my 401(k) into an annuity?

Many people who would benefit from the guaranteed income stream of an annuity lack the cash to make the initial deposit. If you’re in that situation, you may have an alternative: rolling over your 401(k) into an annuity.

One of the advantages of rolling over a 401(k) into an annuity is that you will not be assessed with a distribution tax. When you buy an annuity with IRA or 401(k) funds, the insurance company creates an IRA holding accounts for those funds. For tax purposes, the arrangement is essentially the same as rolling over a 401(k) into another 401(k) or IRA.

You will owe income taxes on 100 percent of each withdraw from the annuity. Plus you will be assessed a tax penalty if you withdraw annuity funds before age 59 ½, the same as you would if you left the money in your 401(k).

The bigger advantage to rolling over 401(k) funds into an annuity is the peace of mind of having a guaranteed income stream and not having your retirement funds exposed to the whims of the stock market.

A hypothetical comparison

Assume you are a 60-year-old man with $500,000 in your 401(k) plan.

If you roll over that money into a fixed immediate annuity paying lifetime income for just the one life, you can receive an estimated $2,500 per month for the rest of your life – guaranteed. That represents about 6 percent of the rollover funds per year.

Even if you take on a provision that guarantees income for a minimum of 15 years – meaning your heirs would receive any remaining funds if you died before receiving payouts for 15 years – you could still collect $2,440 a month. That’s 5.86 percent of your starting annuity account value each year. You could also choose an annuity that increases the income amount each year to help offset inflation, though that will reduce your initial payments.

Now assume you left the money in your 401(k) instead and started drawing income at 60. If you took 6 percent of the initial balance, you would also have $2,500 a month that first year. But your 401(k) account balance would drop to $470,000 after the first year. To maintain a $2,500 monthly payment the next year, you would have to withdraw a higher percentage, 6.4 percent.

But what if in addition to withdrawing $30,000 the first year, the market took a spill and your 401(k) account lost 10 percent of its value due to the downturn? That’s another $50,000 gone, making your account balance $420,000 after the first year. You’ll have to withdraw over 7 percent of the account balance the next year to have $30,000 in yearly income.

Market downturns do double the damage during retirement when you’re withdrawing income. Not only are you depleting your assets by spending them on retirement needs, but you’re also losing money from the market itself.

Even if you reallocate your 401(k) assets to very conservative investments, the small rate of return will not be able to keep up with the amount of withdrawals. Eventually, your account will run out of money.

This isn’t an issue with a fixed annuity because the income is guaranteed for whatever period of time you choose, be it five years, 10 years or for life.

The annuity can be an even better option if you don’t need the income right away and can defer payments for, say, 10 years, when you turn 70. In this scenario, your guaranteed lifetime income will be about $5,145 a month.

Imagine because of a roller coaster market that the 401(k) still has a value of $500,000 10 years later. You would be withdrawing more than 12 percent of its value to obtain that $5,145.

Now let’s add income for your 57-year-old spouse. With the annuity, you can purchase immediate lifetime income for both lives. That means the income will be guaranteed until both of you die. In this scenario, your monthly income drops to $2,150, but it will be guaranteed for both of your lives. If you deferred income for 10 years, you and your spouse could collect nearly $3,900 a month from the annuity until you both passed away.

The 401(k), on the other hand, will only last as long as there is money in the account. It’s possible it could run out before both of you pass away.

On the flip side, the market could have several positive years, meaning your income potential would be greater than with the fixed annuity. If, for example, your 401(k) account grew 5 percent each year for those 10 years, it would be worth more than $814,000 when you began withdrawing funds. At age 70, you could take out 10 percent the first year ($81,400) and still have $732,600. But you have to ask yourself whether your retirement income is worth that risk.

A comparison of options under hypothetical situations given a $500,000 rollover from a 401(k) to annuity or keeping the $500,000 in the 401(k):

Hypothetical Scenario Market total return for 10 years is 0% * Market returns 5% a year for 10 years. Conservative 401(k) allocation earns 1.5% annually
60 YO male rolling over 401(k) into immediate lifetime income annuity Lifetime est. guaranteed annual income: $30,000 Lifetime est. guaranteed annual income: $30,000 Lifetime est. guaranteed annual income: $30,000
60 YO male keeping money in 401(k), withdrawing funds at 60 Withdrawing $30,000/year, account balance after 10 years is est. $168,000. If market stays flat after that, money will run out in less than four more years. Withdrawing $30,000/year, account balance after 10 years is est. $418,240. Even if market stays flat after that, money can last another 14 years. Withdrawing $30,000/year and earning a consistent 1.5% annual return, the account will run out in about 19 years, or age 79.
60 YO male, 57 YO female rolling over 401(k) into immediate lifetime income annuity Lifetime est. guaranteed annual income: $25,800 Lifetime est. guaranteed annual income: $25,800 Lifetime est. guaranteed annual income: $25,800
60 YO male, 57 YO female keeping money in 401(k) and withdrawing funds at 60, 57 Withdrawing $25,800/year, account balance after 10 years is est. $211,225. If market stays flat after that, money will run out in less than nine more years. Withdrawing $25,800/year, account balance after 10 years is est. $473,712. Even if market stays flat after that, money can last more than 18 more years. Withdrawing $25,800/year and earning a consistent 1.5% annual return, the account will run out in about 23 years, or ages 83 and 80.
60 YO male rolling over 401(k) into 10-year deferred annuity until age 70 Lifetime est. guaranteed annual income: $61,470 Lifetime est. guaranteed annual income: $61,470 Lifetime est. guaranteed annual income: $61,470
60 YO male keeping money in 401(k) and waiting 10 years Account value is est. $500,000. If you withdraw $61,470, account could be depleted in less than 10 years if market doesn’t rebound. Account value is est. $814,000. If you withdrew $61,470 annually, account could last 13 years even if market stays flat. Account value is est. $580,270 after 10 years. If you withdrew $61,470 a year and continued to earn consistent 1.5% annually, the account would run out in just over 19 years, or age 79.
60 YO male, 57 YO female rolling over 401(k) into 10-year deferred annuity until age 70, 67 Lifetime est. guaranteed annual income: $46,800 Lifetime est. guaranteed annual income: $46,800 Lifetime est. guaranteed annual income: $46,800
60 YO male, 57 female keeping money in 401(k) and waiting 10 years Account value is est. $500,000. If you withdraw $46,800, account could be depleted in less than 12 years if market doesn’t rebound. Account value is est. $814,000. If you withdrew $46,800 annually, account could last more than 17 years even if market stays flat. Account value is est. $580,270 after 10 years. If you withdrew $46,800 a year and continued to earn consistent 1.5% annually, the account would run out in about 23 years, or ages 83 and 80.

 

*For illustrative purposes, assume the market lost 10 percent the first year, gained 10 percent in year two, lost 10 percent in year three, etc.