How to Use Your 401(k) to Buy an Annuity: Treasury Rules Explained

For most of your working life, your 401(k) is an investment account. You contribute money, choose some funds, and watch the balance grow over time. But when you retire, you face a challenge that your 401(k) was never really designed to solve on its own: turning that lump sum into a reliable paycheck that lasts as long as you live. That is where annuities come in.

An annuity is an insurance contract that converts a pile of money into guaranteed monthly income, often for life. For years, using your 401(k) to buy an annuity was possible but rare, partly because employers were nervous about the legal risks of choosing an annuity provider for their employees. The Treasury Department and Congress changed that with a series of rules and laws designed to make annuities a practical and protected option inside workplace retirement plans.

In this article, we will explain how the Treasury rules work, what the SECURE Act changed, and how you can use your 401(k) to purchase an annuity. We will also cover the tax implications, portability rules, and the different types of annuities available inside retirement plans.

Why the Treasury Opened the Door to Annuities in 401(k) Plans

The shift from pensions to 401(k) plans over the past 40 years created a retirement income gap. With a pension, your employer promised to pay you a set amount every month for life. With a 401(k), you get a lump sum and have to figure out how to make it last. This is a difficult problem, especially when you do not know how long you will live, what the stock market will do, or what inflation will look like in 20 years.

The Treasury Department recognized this problem and began issuing guidance to encourage the use of lifetime income options, including annuities, inside defined contribution plans like 401(k)s. In 2012, the Treasury and Department of Labor jointly issued proposed rules aimed at helping workers understand the lifetime income value of their 401(k) balances. These proposals were part of a broader push to get Americans thinking about retirement savings not as a pile of money but as a source of monthly income.

The real breakthrough came with the SECURE Act (Setting Every Community Up for Retirement Enhancement), signed into law in December 2019. This law included a fiduciary safe harbor for employers who offer annuities in their plans, removing the biggest legal barrier that had kept most companies from adding annuity options to their 401(k) lineups.

The SECURE Act Safe Harbor: What It Means for You

Before the SECURE Act, employers who added an annuity option to their 401(k) plan took on the risk that they could be sued if the insurance company failed to pay claims or went bankrupt. This fiduciary liability was a major deterrent. Even if an employer believed an annuity was a great option for their employees, the legal risk was simply too high for most companies to accept.

The SECURE Act addressed this with a fiduciary safe harbor. Under this provision, an employer will not be held liable for selecting an annuity provider as long as certain conditions are met. The employer must verify that the insurance company is licensed in the state where the plan is operated and that the company has been meeting its financial obligations. The employer should also consider the insurer's financial capability at the time of selection.

For you as an employee and plan participant, this means more 401(k) plans are likely to offer annuity options in the coming years. If your plan already includes annuities, you can feel confident that your employer followed a legally defined process when selecting the insurer. If your plan does not yet offer annuities, you can ask your HR department or plan administrator whether they plan to add this option.

Types of Annuities Available in 401(k) Plans

Not all annuities are the same, and the type available in your 401(k) depends on what your employer's plan offers. Here are the most common types you might encounter.

Fixed Annuity

A fixed annuity pays you a guaranteed interest rate on your money during the accumulation phase and a fixed monthly payment during the payout phase. This is the simplest type of annuity and carries the least risk. You know exactly how much you will receive each month. The downside is that fixed payments do not keep up with inflation over time.

Target-Date Fund with Annuity Component

Some plan providers now offer target-date funds that gradually shift a portion of your balance into an annuity as you approach retirement. In your early years, the fund invests primarily in stocks and bonds. As your target retirement date gets closer, the fund begins purchasing annuity contracts with a portion of the balance, so that by the time you retire, a piece of your savings is already converted into guaranteed income. This approach automates the transition from saving to income.

Guaranteed Minimum Withdrawal Benefit (GMWB)

A GMWB is a type of rider attached to a variable annuity or managed account. It guarantees that you can withdraw a certain percentage of your balance each year for life, even if the underlying investments lose value. This gives you market upside potential with a floor of guaranteed income. GMWBs typically charge an annual fee, usually between 0.5 and 1.5 percent of the account value.

Deferred Income Annuity (DIA) or QLAC

A deferred income annuity purchased within a 401(k) works the same way as one purchased in an IRA. You invest a lump sum, choose a future start date, and receive guaranteed monthly income beginning at that date. If the annuity qualifies as a QLAC, the invested amount is excluded from your required minimum distribution calculations, which can lower your taxes during the deferral period.

The Portability Rule: What Happens When You Leave Your Job

One of the biggest concerns people have about buying an annuity inside a 401(k) is portability. What happens if you change jobs? What if your employer decides to drop the annuity option from the plan? The SECURE Act addressed these questions with a portability provision.

Under the SECURE Act, if your 401(k) plan eliminates its annuity option or if you leave your employer, you have several choices for your annuity. You can roll the annuity into an IRA. You can roll it into your new employer's 401(k) plan if that plan accepts rollovers. You can also take a distribution of the annuity contract itself, moving it outside of the retirement plan. In most cases, these transfers can be done without triggering taxes or penalties, as long as the rollover is completed properly.

This portability rule was a critical addition because it removed one of the major objections employees had to buying annuities in their workplace plans. Before the SECURE Act, there was a real risk that you could be stuck with an annuity you could not move, or that moving it would trigger a taxable event. Those concerns are now largely resolved.

Tax Rules for 401(k) Annuities

The tax treatment of a 401(k) annuity follows the same rules as any other 401(k) distribution. If your money is in a traditional (pre-tax) 401(k), every dollar you receive from the annuity is taxed as ordinary income. If your money is in a Roth 401(k), the payments are generally tax-free as long as you meet the five-year holding requirement and are at least 59 and a half years old.

There is an important distinction between buying an annuity inside your 401(k) versus rolling funds out to buy one on the individual market. When you buy an annuity inside the plan, no taxable event occurs because the money stays within the tax-deferred wrapper. If you withdraw money from your 401(k) to buy an annuity on your own, the withdrawal is taxable (and potentially subject to a 10 percent early withdrawal penalty if you are under 59 and a half). This is why many advisors recommend either buying the annuity inside the plan or doing a direct rollover to an IRA first.

Required Minimum Distributions and 401(k) Annuities

If you own an annuity inside a traditional 401(k), you still need to satisfy required minimum distributions starting at age 73 (rising to 75 in 2033). The annuity payments themselves can count toward your RMD for the year, as long as the payments meet or exceed the required distribution amount. If the annuity payments are less than your RMD, you will need to withdraw additional funds from the plan to make up the difference.

If the annuity inside your 401(k) is structured as a QLAC, the value of the QLAC is excluded from your RMD calculations until payments begin. This can significantly reduce your RMDs and your tax bill during the deferral period. Once QLAC payments start, they count as taxable distributions for that year.

How to Decide If a 401(k) Annuity Is Right for You

Buying an annuity inside your 401(k) is not the right move for everyone. Here are some factors to consider as you weigh your options.

• Your comfort with market risk. If you are anxious about stock market volatility and want the peace of mind that comes with a guaranteed paycheck, an annuity can provide that certainty. If you are comfortable managing your own withdrawals and have a diversified portfolio, you may prefer to keep your money invested.
• Your other sources of income. If you already have a pension and Social Security that cover your basic expenses, you may not need an annuity for additional guaranteed income. But if your 401(k) is your primary retirement savings and you have no pension, an annuity can fill the role of a personal pension.
• Your health and life expectancy. Annuities pay off the most when you live a long time. If you are in good health with a family history of longevity, a lifetime annuity is more likely to provide value. If you have serious health conditions that may shorten your life, you might be better off keeping the money liquid.
• The fees involved. Annuities inside 401(k) plans may benefit from institutional pricing, which is typically lower than retail pricing. However, you should still compare the costs. Ask about the annuity's internal fees, any surrender charges, and how the payout rate compares to what you could get on the individual market.

Rolling Over Your 401(k) to Buy an Annuity in an IRA

If your 401(k) plan does not offer an annuity option, or if you want access to a wider range of annuity products, you can roll your 401(k) into an IRA and purchase an annuity there. This is a common strategy for people who are retiring or leaving their employer.

The process is straightforward. You request a direct rollover from your 401(k) to a traditional IRA. The money moves directly from the plan custodian to the IRA custodian, so there is no taxable event. Once the funds are in the IRA, you can use them to purchase any annuity product that the IRA custodian supports, including fixed annuities, indexed annuities, income annuities, and QLACs.

The key advantage of buying an annuity in an IRA is choice. Instead of being limited to the one or two annuity options your employer selected, you can shop around and compare products from dozens of insurance companies. A licensed agent can help you get quotes and evaluate which annuity offers the best payout rate, the strongest insurer financial rating, and the features that matter most to you.

Common Mistakes to Avoid

When using your 401(k) to buy an annuity, there are a few pitfalls to watch out for.

1. Do not take a cash distribution first. If you withdraw money from your 401(k) and then use it to buy an annuity, you will owe income tax on the withdrawal. Always use a direct rollover or buy the annuity inside the plan to avoid an unnecessary tax hit.
2. Do not put all your money into an annuity. Annuities provide guaranteed income, but they are generally illiquid. Keep enough money in accessible investments to cover emergencies, unexpected expenses, and any large purchases you anticipate in the near future.
3. Do not ignore the insurer's financial strength. Your annuity payments are only as reliable as the insurance company behind them. Check the insurer's ratings from agencies like AM Best, Moody's, and Standard & Poor's. Look for companies rated A or higher.
4. Do not forget to compare quotes. Annuity payout rates vary significantly from one insurance company to another. A difference of even a few dollars per month can add up to thousands of dollars over a 20 or 30-year retirement. Always get multiple quotes before making a decision.

The Lifetime Income Disclosure Requirement

Another provision of the SECURE Act requires 401(k) plan statements to include a lifetime income disclosure at least once a year. This disclosure shows you what your current 401(k) balance could provide in monthly income if it were used to purchase a single life annuity or a qualified joint and survivor annuity. The purpose of this requirement is to help you think about your savings in terms of income rather than just a total dollar amount.

For example, your statement might show that your $500,000 balance could produce approximately $2,200 per month in lifetime income. Seeing this number can be a wake-up call for some people, either motivating them to save more or encouraging them to consider actually purchasing an annuity to lock in that income.

Talk to a Licensed Agent About 401(k) Annuity Options

Deciding whether to use your 401(k) to buy an annuity is one of the most important financial decisions you can make as you approach retirement. The Treasury and IRS rules are designed to protect you, but the details can be complex. A licensed insurance agent can walk you through your options, help you compare annuity quotes, and explain how an annuity fits alongside Social Security and your other retirement savings.

Whether you want to buy an annuity inside your existing 401(k), roll over to an IRA for more choices, or explore a QLAC for late-life income, our agents can help you find the right solution. Contact us today for a free, no-obligation consultation and take the first step toward guaranteed retirement income.