Since their introduction in 1978, 401(k) plans, have become the predominate vehicle for retirement savings and have become the foundation for a secure retirement for millions of Americans. Offered by employers as an inducement for employees to systematically save for retirement, 401(k) plans provide plan participants with tax advantages, investment choices, flexibility and the best opportunity for accumulating the large chunk of money they will need to retire in comfort. You will find no argument from among financial planners that, anyone with access to a 401(k) plan should take full advantage it for all it can offer.
401(k) plans are tax qualified plans which means that contributions are made on a pre-tax basis, and the earnings are allowed to accumulate without current taxation. This provides plan participants with a unique opportunity to maximize their returns by saving immediately on income taxes and by postponing the taxes owed on earnings.
The Limiting Effect of 401(k) plans
As great as 401(k) plans are, they contain some provisions that some investors may find somewhat limiting on their road to maximizing their retirement income which could lead some to exploring alternative means to accumulating retirement funds, not necessarily as a replacement for their 401(k), but, rather, as a supplement.
The first limitation of 401(k) plans is the cap on annual contributions presently set at $16,500. While this is may be a significant amount for most people, some have the means and the desire to contribute more towards their retirement.
Annuities may offer the best opportunity for pre-retirees to maximize their retirement savings in a tax advantaged way. As a non-qualified retirement savings plan, annuity contributions are made with after-tax dollars, but they provide the same tax deferral on earnings as a qualified plan such as a 401(k). Additionally, there are no limitations on the amount that can be contributed to annuities.
For investors who are still feeling the sting of declining 401(k) values as a result of the recent market turmoil, annuities offer the unique advantage of protecting your principal from market declines. All annuities offer a death benefit that is at least equivalent to your original principal. And some variable annuities, which enable you to participate in the higher returns of the stock and bond markets, include mechanisms that limit or eliminate the downside risk as well.
Perhaps the most tragic result of the recent stock market declines and volatility was the decimation of account values in millions of 401(k)s. In the wake of that financial storm, it became apparent to many pre-retirees that they no longer have the funds to be able to generate a secure income for their lifetimes. Managing a lump sum of money for a lifetime of income has always proved difficult for retirees, and now, as those lump sums have shrunk, it becomes even more difficult. As a result, more employer sponsors of 401(k) plans are turning towards annuities as an investment choice for plan participants.
The notion of managing a large asset for income purposes was never a concern for people who retired with a pension, or a defined benefit plan that, essentially, produced a guaranteed stream of income for the life. As defined contribution plans, such as 401(k)s have replaced defined benefit plans, the onus of managing the money for income has fallen on retirees, most of whom are ill-equipped for the task.
Annuities as an Income Security Alternative
Annuities are the only investment vehicle that can replicate the guaranteed income property of a defined benefit plan, so, in response to the precarious position in which their employees find themselves, employers are adding annuities as an alternative investment choice. This is because annuities, when annuitized, or converted to income, will generate a secure and predictable stream of income that cannot be outlived.
If your employer doesn’t offer annuities as an option, it may be worth considering adding some to your portfolio outside of your 401(k) plan. Or, for those who don’t have the means to make additional investments outside of your 401(k), it might even make sense to divert some of your contribution to a non-qualified annuity in order to build in an income safety net. The advantage to owning annuities outside of a 401(k) is that you will still benefit from the tax deferral on earnings, and, they can be accessed at any time in retirement, for withdrawals or as an income stream without regard to the Required Minimum Distribution* rules that apply to 401(k) plans.
You would be hard pressed to find a financial advisor who would advise against taking maximum advantage of your 401(k) for all of its tax benefits and ease of investment, however, in the face of decimated retirement accounts and continued economic uncertainty, more advisors are pointing their client towards annuities for the ultimate in retirement income security.
*The Required Minimum Distribution from qualified retirement plans was temporarily suspended by Congress for 2009 due to the economic downturn.