Buying an annuity inside a 401(k) or IRA usually wastes the tax shelter
No. In most cases, you should not buy an annuity inside a tax-advantaged account like a 401(k), IRA, or 403(b). The reason is straightforward: annuities already have built-in tax deferral, so putting them in an account that already defers taxes creates a mismatch that costs you money in fees without giving you any tax benefit in return.
An annuity is a contract with an insurance company where you pay a lump sum and receive may provide monthly payments for life (or a set period). The insurance company charges fees for that may provide—typically 0.5% to 3% per year, sometimes higher. Inside a tax-advantaged account, those fees are the only thing you get. Outside the account, the tax deferral is the benefit. Inside the account, you pay the fees but lose the tax advantage, because the account is already deferring taxes on everything inside it.
There are narrow exceptions—mainly if your 401(k) plan offers an annuity option and you want may provide income in retirement, or if you are using a specific type called a may have access to longevity annuity contract (QLAC). But for most people, the math does not work.
Key Takeaways
- Annuities already defer taxes on their own, so putting one inside a 401(k) or IRA means you pay insurance fees without gaining any tax shelter benefit.
- The fees inside an annuity—often 1% to 3% per year—compound over decades and reduce your retirement income more than the tax deferral would help.
- A QLAC (may have access to longevity annuity contract) is a narrow exception that lets you convert up to $145,000 of IRA or 401(k) money into may provide lifetime income without counting it toward required minimum distributions.
- If your employer plan offers an annuity option at low cost and you want may provide income, it may be worth considering, but only if the fees are transparent and below 0.75% per year.
- For most retirees, buying an annuity outside a tax-advantaged account (if you want one at all) and keeping stocks and bonds inside the account is the lower-cost approach.
How annuities and tax deferral work separately
An annuity is a contract between you and an insurance company. You give them money upfront, and they promise to pay you a set amount each month for the rest of your life (or for a number of years you choose). The insurance company keeps the money you do not receive yet and invests it. The growth on that money is not taxed until you receive it as a payment.
A tax-advantaged account like a 401(k) or traditional IRA works the same way: money grows inside without being taxed each year. You pay tax only when you withdraw it in retirement. Both mechanisms defer tax on growth. When you put an annuity inside the account, you are paying for tax deferral twice—once built into the annuity contract, and once built into the account itself. You only benefit from one of them.
The cost of that redundancy is the annuity's fees. An insurance company charges you to may provide your income. Those fees—wrapped into the annuity's price or charged annually—are what you lose when the tax deferral benefit disappears.
The fee problem: why annuities inside accounts cost more than they help
Annuities charge fees in several ways. Some have a one-time cost built into the purchase price (the insurance company keeps a percentage of your money). Others charge annual fees ranging from 0.5% to 3% or more, depending on the type and the guarantees included. Some charge both.
Over 20 or 30 years, even a 1% annual fee compounds into a significant loss. If you invest $100,000 in an annuity with a 1% annual fee inside a 401(k), that fee alone costs you roughly $20,000 to $30,000 in lost growth by the time you retire, depending on market returns. You paid that fee to get tax deferral—but the 401(k) was already deferring taxes for free.
If you had instead kept a low-cost stock or bond fund inside the 401(k) (which costs 0.03% to 0.20% per year) and bought the annuity outside the account with after-tax money, you would have paid the annuity fee anyway, but you would have kept the tax deferral benefit of the account for investments that actually need it.
When a QLAC makes sense
A QLAC (may have access to longevity annuity contract) is a specific type of annuity designed to work inside IRAs and 401(k)s. The IRS allows you to convert up to $145,000 of your IRA or 401(k) money into a QLAC without that money counting toward your required minimum distributions (RMDs) in retirement.
This matters because RMDs force you to withdraw money from your account each year starting at age 73, and those withdrawals are taxed as income. If you convert some of that money into a QLAC that does not pay out until age 80 or 85, you reduce your RMD and delay taxes on that portion. The QLAC still charges fees, but the tax delay on the RMD can offset some of that cost.
A QLAC is worth considering if you expect to live well into your 80s or 90s, want may provide income later in retirement, and are looking for a way to reduce RMDs. But it is still a narrow use case. You need to run the numbers with a tax professional to see whether the RMD savings outweigh the annuity fees.
When your employer plan offers an annuity option
Some 401(k) and 403(b) plans offer annuities directly as an investment choice within the plan. These are sometimes cheaper than buying an annuity on the open market, because the plan negotiates rates with the insurance company and spreads administrative costs across many employees.
If your plan offers an annuity and the fees are transparent and below 0.75% per year, and you genuinely want may provide income in retirement, it may be worth considering. The advantage is that you avoid shopping on the open market, where annuity fees can be much higher and harder to understand.
But before you buy, ask your plan administrator for the exact annual fees in writing. If they cannot tell you clearly, or if the fees are above 1%, you are better off keeping your money in the plan's regular investment options and buying an annuity outside the plan if you decide you want one later.
The better approach: annuities outside the account
If you decide you want an annuity for may provide income in retirement, buy it outside a tax-advantaged account using after-tax money. Keep your 401(k) and IRA invested in low-cost stock and bond funds that cost 0.03% to 0.30% per year to own.
This way, you get the tax deferral benefit of the account (where it actually saves you money), and you get the may provide income from the annuity (where you are willing to pay the fee for peace of mind). You are not paying for the same benefit twice.
The trade-off is that you will owe taxes on the annuity income when you receive it, because it came from after-tax money. But that is a smaller cost than paying annuity fees on money that was already getting tax deferral inside the account.
What to ask before you buy
If a financial advisor or insurance agent recommends an annuity inside your 401(k) or IRA, ask these questions in writing:
- What is the total annual cost of this annuity, expressed as a percentage of my money?
- What tax benefit do I get from buying this annuity inside this account that I would not get from buying it outside?
- How much will this annuity cost me over 10, 20, and 30 years compared to keeping my money in the plan's regular investment options?
- Is this a QLAC, and if so, how much will it reduce my required minimum distributions?
If the advisor cannot answer these questions clearly, or if the answer to question 2 is "none," do not buy. The math does not work for most people.
Frequently Asked Questions
Can I move an annuity out of my 401(k) if I already bought one?
Yes, but it depends on your plan and the annuity contract. Some plans allow you to exchange an annuity for other investment options without penalty. Others do not. Check your plan documents or call your plan administrator. If you can move it, you may owe surrender charges to the insurance company, so get those in writing before you act.
What if I want may provide income and I am close to retirement?
If you are within five years of retirement, the fee problem is smaller because the fees have less time to compound. An annuity inside your account may still not be the best choice, but it is less clearly wrong. Run the numbers with a fee-only financial planner (one who does not sell annuities) to compare the cost of an annuity inside versus outside your account.
Is a variable annuity different from a fixed annuity?
Yes. A fixed annuity pays you a set amount each month. A variable annuity lets you choose how the insurance company invests your money, and your payment varies based on how those investments perform. Variable annuities have higher fees (often 1% to 3% per year) because of the investment management. Neither should be inside a tax-advantaged account for the reasons explained above.
What about when ready annuities?
An when ready annuity is one where you pay a lump sum and payments start right away (usually within a month). These have lower fees than variable annuities, sometimes 0.5% to 1% per year. But the same logic applies: if you buy one inside a 401(k) or IRA, you are paying for tax deferral you already have. Buy it outside the account if you want one.
Do I need to report an annuity inside my IRA to the IRS?
Your IRA custodian (the bank or brokerage holding your account) reports the annuity to the IRS as part of your annual IRA statement. You do not file a separate form unless you are taking distributions from the annuity. When you do take distributions, they are taxed as ordinary income, just like any other IRA withdrawal.