An IRA by any other name...

If you're leaving your job to work for yourself, should you roll your 401(k) into an IRA annuity? Not so fast, says Walter Updegrave.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: My wife recently left her job and is going to work part-time for herself. We have been advised by our financial adviser to roll her 401(k) into something called an "IRA annuity." What are the benefits and drawbacks to doing this as opposed to simply rolling the money into a regular IRA invested in low-cost mutual funds? -Todd, Lebanon, Pennsylvania

Answer: Judging by the number of emails I get from people who have received similar pitches, I can only surmise that there's a sizeable army of planners, brokers, insurance agents and other advisers out there intent on convincing people how much better off they would be if they'd only switch their 401(K) money into an IRA annuity (which, by the way, is nothing more than an annuity held inside an IRA account).

That's unfortunate. Why? Well, although there are instances when holding an annuity in an IRA can make sense - and I'll get into those later - that's usually not the case. Which makes me wonder whether these IRA annuity pitches are thinly disguised schemes for enticing people to put their 401(k) stash into an investment that's larded with extra fees that benefit the adviser more than the investor.

But to answer your question, let's step back a minute and think about what someone in your wife's position - that is, someone who's left a job but isn't ready to retire just yet - should be looking to do with the money she's accumulated in a 401(k).

I think the answer is rather obvious. Her goal should be to have that money to continue to grow free of taxes so that come retirement time she'll be able to draw more income from it.

There are a couple of ways of achieving that goal. If her 401(k) plan has excellent investment options, she could simply leave the money in the plan and let it continue to rack up tax-deferred gains there. Or, as you suggest, she could transfer the money into an IRA rollover account - which preserves its tax-advantaged status - and invest in a diversified portfolio of stock and bond mutual funds appropriate for someone her age.

Generally, I think you're better off going the IRA rollover route because it gives you a broader array of investment options than most 401(k)s and you don't have to deal with an employer you no longer work for. But whichever route you choose, the important thing is that your 401(k) continues to grow without the drag of taxes.

So why, you may ask, should someone even consider an IRA annuity? Well, one feature of an annuity is that investment gains aren't taxed as long as they stay inside the annuity. But even annuity issuers admit that tax-deferral isn't a selling point when 401(k) money is involved, since both the 401(k) and the IRA rollover automatically shelter your gains from taxes. So what advantage can the IRA annuity offer?

These days the people who tout IRA annuities like to point to what they call "living benefits." Essentially, these are riders that are attached to a variable annuity, which is a type of annuity that allows you to invest in mutual-fund like accounts. Although there are several different types of living benefits, the two most commonly sold are affectionately known in annuity circles as the GMIB and the GMWB.

The GMIB, or guaranteed minimum income benefit, basically promises that if you hold your variable annuity for a certain amount of time (usually at least 10 years), you'll be assured of receiving a minimum annual income even if your annuity's investment options perform abysmally. The GMWB, or guaranteed minimum withdrawal benefit, guarantees that, regardless of how your annuity's investment accounts perform, you'll be able to withdraw a certain percentage of your original investment (usually 4 percent to 6 percent) for life.

At first glance, both of these options seem like terrific deals. Guaranteed income even if the financial markets experience a meltdown - what could possibly be wrong with that?

Well, two things. One is if you take the trouble to plow through the hefty prospectus (which can easily run 400 or more pages) that comes with these products, you'll find that they're riddled with restrictions and drawbacks that make them a lot less attractive than the picture the adviser paints. (The fact that they're hideously complicated is another downside in and of itself.)

The other problem is the cost. Variable annuities usually tend toward the blimpish end of the fee spectrum, with annual levies of 2 percent or more of assets hardly uncommon. Throw in the extra charges for these riders and you could be talking an all-in cost of 3 percent or more a year. That's a huge portion of your assets to be giving up year after year. Lack of space and fear of causing a terminal case of boredom prevent me from going into the ugly details of these products here. But I can refer you to what I've written in the past about GMIBs and GMWBs.

Ultimately, though, my position boils down to this: if you've got 401(k) money you're not planning on tapping within a few years or longer, you're much better off rolling it into an IRA rollover invested in a mix of low-cost stock and bond mutual funds that's appropriate for your age and risk tolerance and letting it rack up returns.

Without the drag of all those annuity fees, you'll likely end up with a larger nest egg to tap at retirement. It's at that point, when you're ready to tap your IRA stash for income, when an annuity might make sense. Not a variable annuity with one of those riders. But a plain, old-fashioned immediate annuity (aka an income or payout annuity) which converts a lump sum of cash into a lifetime income. (For an idea of how much income you might receive for different amounts of money and different ages, click here.)

You don't want to put all your money in an immediate annuity. You'll want to have plenty of other assets that can provide long-term growth to maintain your purchasing power in the face of inflation and liquidity in case you need extra cash for emergencies or a well-deserved splurge. So a strategy I recommend for people who want more guaranteed monthly income than Social Security alone can generate is to devote a portion of their stash to an immediate annuity and the rest to a diversified mix of low-cost funds. (You can learn more about the benefits of such a strategy by clicking here.)

So my advice is to ignore your adviser's recommendation in this case. And while you're at it, you might want to consider consulting a new adviser, preferably one who's not so enamored of IRA annuities and who might even help you carry out the strategy I recommend. Top of page