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Should you lock your money in a 401(k) annuity?

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in Small Business Tax,Small Business Tax Deduction Strategies

As you continue to salt away money in your 401(k), you might wonder how you’ll create a steady income in retirement. Should you consider the financial services industry’s new pitch: the 401(k) annuity?

Strategy: Don’t dive into the pool’s shallow end. If you can offer this 401(k) feature, weigh your options carefully before committing.

The premise is simple: An annuity resembles the big company pension plans from days of yore. It takes the worry out of managing 401(k) funds after you retire. And, by going through your 401(k), it eliminates comparison-shopping the dizzying array of annuities in the retail market.

In effect, you’re acquiring a “do-it-yourself pension” with little muss or fuss.

But this new financial product has potential drawbacks. Although the fees are usually lower than retail annuity fees, the annual expenses can be double those for other 401(k) investments. Plus, it could be awkward to handle if you leave for another job. Finally, the guarantee behind the annuity is only as good as the issuer’s financial condition (although state law may bail you out if the issuer becomes insolvent).

Tax tip: No tax is due on an annuity’s inside buildup until you start receiving payments. Generally, you must pay a 10% penalty on withdrawals made prior to age 591/2 on top of the regular income tax you’ll owe. The IRS taxes payments at ordinary income tax rates whether you invest inside or outside a 401(k).

Also, for annuities purchased in the retail market, the issuer may impose surrender charges on early withdrawals. But surrender charges don’t apply to 401(k) annuities.

Fixed vs. variable annuities

Annuities come in two flavors: fixed and variable. You’ll need to choose one for a 401(k) investment, so it’s important to know the differences.

Fixed annuity option: As the name implies, this pays a fixed amount at regular intervals for a set time. The annuity issuer guarantees payments, tied to the government-backed securities’ performance.

If you invest in a fixed annuity inside a 401(k), the prevailing interest rates and your age will affect your payments. The earlier you invest and the higher the interest rate, the bigger the payout.

The primary attraction to fixed annuities is that you know exactly what you’re getting.

Example: You begin contributing $100 a month to an annuity when you turn age 50. The annuity issuer guarantees to pay $10 per share each month starting at age 65.

After you’ve contributed $18,000 to the fund, you accumulate 20 shares. Result: The annuity will pay you $200 a month for life.

If you pony up $300 a month while you’re working, the monthly payment in retirement would be $600. For a monthly contribution of $500, you’ll receive $1,000 each month.

Note that fixed annuities generally don’t take inflation into account. So the money you receive years from now won’t buy as much as it does today.

Variable annuity option: With a variable annuity, the investment return is tied to the underlying account’s performance. Since the funds are generally invested in stocks and bonds, the annuity’s value will reflect market ups and downs.

Thus, the payments you receive in retirement may keep up with or surpass inflation. On the other hand, you also bear the risk of an economic downturn.

Example: You invest in an annuity at age 45. If you invest $100,000 prior to age 65, you may receive an annual payment in retirement between $15,000 and $25,000. Note: The annuity issuer charges a fee each year for managing the account.

Of course, the actual figures for your situation will vary, but you get the big picture: A variable annuity offers greater chance for reward at a higher risk.

Tip: Weigh the pluses against the minuses. A 401(k) annuity could make sense if you crave more security in your retirement years.

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