What is a 401k Annuity
The 401k – sometimes styled 401(k) – is a qualified retirement plan first offered in the United States in 1978. Although originally intended for senior level corporate executives, over time it became popular among individuals of all income levels and became one of the major retirement plans utilized in the United States along with the Individual Retirement Account (IRA). The 401k gets its name from the section of the Internal Revenue Code (also known as Title 26 of the United States Code), which defines it and gives it its legal standing. Although the 401k is usually thought of as an employer-sponsored benefit largely separate from the realm of insurance, it can be utilized by individuals as a qualified annuity plan under certain circumstances. Apart from the fact a 401k annuity is issued by a life insurance company and as such pays a death benefit, there is no appreciable difference between it and a 401k issued by other means.
Opening a 401k Annuity as an Individual
The main difference between a 401k and an IRA is that a 401k must be set up by an employer whereas an IRA can be opened by an individual. Self-employed individuals may set up 401k plans under the guise of a sole proprietorship, LLC or other corporate construction. Allowable annual contributions for 401ks are significantly higher than for IRAs ($16,500/year vs. $5,000/year for individuals under 50 in most cases, not counting employer matching contributions). An added advantage of opening a 401k annuity as a self-employed individual is that it is relatively easy to leverage that product to provide 401k plans to any employees that self-employed individual may have.
Because all forms of the 401k offer higher contribution levels than IRAs, they are often quite advantageous over the IRA for both self-employed individuals and for their employees alike. It is possible to roll over IRA funds into a 401k, but keep in mind that any rollover amount from an IRA counts towards one's 401k annual contribution limit.
401k Annuity Variants
Self-employed individuals with employees may choose to open their 401k annuity plan as a Savings Incentive Match Plan For Employees Of Small Employers, or SIMPLE 401k. The SIMPLE 401k is advantageous in that it doesn't require self-employed individuals to devote overhead to legal compliance testing (such as proving compliance with non-discrimination statutes), which is required for a traditional 401k. This in turn saves on administrative costs. Like a traditional 401k , the SIMPLE 401k also allows for employers and employees alike to borrow against their account balances.
However, the SIMPLE 401k also mandates lower contribution limits than other 401k constructs (a maximum possible contribution of $18,850/year in 2009, including employer contributions), and is not available to companies with more than 100 employees. The SIMPLE 401k annuity may be a good choice for self-employed individuals who wish to provide benefits to their employees, but who do not anticipate growing their company beyond 100 employees.
If a self-employed individual opens an annuity as a qualified Simplified Employee Pension Plan (SEP), the contribution limits can be even higher. Under SEP rules in 2009 one can annually contribute as much as 25 percent of total income or $49,000/year, whichever is less. When the SEP is constructed as a 401k annuity, exact annual contribution limits can vary depending on how a self-employed individual is organized (i.e. as a sole proprietorship, an LLC, etc.), however the limits often remain significantly higher than allowable by other means. A SEP 401k can only be opened for the self-employed individual and his or her spouse, and only then if the spouse is an employee. No other employees are allowed in the plan. Because the SEP 401k offers the most generous contribution limits of any 401k plan, it may be the best choice for the self-employed individual who is primarily looking to start a 401k for themselves rather than for employees.
Both SIMPLE and SEP 401k plans are immediately fully vested, meaning that any and all employer contributions to their 401k plans immediately become pretty much their property to do whatever they want with, up to and including early withdrawal or rollover of their entire 401k balance at any time. By contrast, traditional 401k plans often provide for a time frame in which employer contributions become vested.
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Traditional or Roth? Fixed or variable
As with IRAs, there are two main forms of 401k plans. A traditional 401k receives tax-free contributions with distributions paid at normal tax rates. Contributions to a Roth 401k are made after-tax, but distributions are tax free. As with IRAs, 401k distributions may be taken without penalty at age 59 ½ and must be taken by age 70 ½.
As with other types of qualified annuity products, 401k annuities are typically available in fixed and variable forms. A fixed annuity is one that offers a stated, guaranteed interest rate on your investment similar to a savings account. Fixed annuities are considered conservative and safe. However, the rates of return they provide are often lower than by other available means.
A variable annuity works similar to a mutual fund, with contributions funding “separate accounts” comprised of stocks, bonds and other financial instruments. Variable annuities can be tailored to meet individual needs with conservative, aggressive and median separate accounts available. While rates of return on variable annuities traditionally outperform fixed annuities in the long run, they do involve risk and can lose money. Hybrid plans, such as an indexed 401k annuity pinned to the performance of a major stock index such as the Standard and Poor's Index, may also be available. An insurance agent must hold the appropriate FINRA securities licenses as mandated by state law to sell variable annuities. Don't be afraid to check credentials.
Companies Offering 401k Annuities
Nationally-recognized life insurance companies currently offering 401k annuities include MetLife, Genworth Financial, Hartford Life Insurance Company, Prudential and Mutual of Omaha. Smaller, regional life insurance companies also offer competitive 401k annuity plans. Check with a local insurance agent for more information.
As with any major insurance purchase, be sure to check the A. M. Best rating for any prospective 401k annuity underwriter. A++ and A+ ratings are the best (smaller life insurance companies are often ineligible for the A++ simply because of their size; as such the A+ rating can be considered on par with the A++ in most respects). Steer clear of anyone who rates lower than a B+ or doesn't have a current A. M. Best audit.
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