Annuity vs. mutual fund: Comparing 5 key differences

As you approach retirement, you have several important decisions to make about managing your nest egg. You've worked hard to accumulate savings, and there are multiple ways to convert those savings to income. Annuities and mutual funds are both popular options, but they each come with their pros and cons.

So, how do you evaluate the choice between an annuity vs. mutual fund? Comparing them side by side can help you decide if one or the other (or both) fits into your financial strategy.

Annuities are insurance products designed to provide guaranteed lifetime income. You add funds to an annuity, and then you have the choice to set up regular payments for yourself—perhaps monthly or annually—when you're ready to retire or at a later date that you choose. Several types of annuities exist so you can select the most important features for your needs.

Mutual funds are pooled investments that combine money from numerous investors. A fund typically has a specific objective, and the investments will match that objective. For example, a large company mutual fund might invest in several hundred or more large companies. Mutual funds have a range of risk and return profiles, allowing you to build a portfolio that's aligned with your goals.

The differences between annuities and mutual funds come down to taxes, returns, their primary purpose, liquidity and cost.

Annuities are tax-deferred, so you generally don't report earnings inside the contract each year. Instead, you typically only report income when you take withdrawals. If you fund the contract with after-tax dollars, you might only owe taxes on the earnings while your original investment comes back out without taxation. As part of the benefit of tax-deferral, you must keep the money in an annuity until at least age 59½. Otherwise, a 10% federal tax penalty may apply to distributions in addition to ordinary income taxes.

Meanwhile, mutual funds can create taxable income when you hold them in a taxable account (such as an individual brokerage account or a joint account). When mutual funds distribute capital gains or dividends, that income gets reported to the IRS, and will be included as income on your tax return.

One thing to note is that when you hold assets in a retirement account such as an IRA, earnings are typically tax-deferred regardless of whether you use an annuity or a mutual fund. The account itself holds off taxes until you take distributions, at which time they are usually taxed as ordinary income. It's always a good idea to work with your accountant or tax advisor before taking distributions from any product.

The earnings from a mutual fund depend on how the investments in the fund perform. If they do well, you might benefit from healthy returns over the long term. But high returns are usually only possible with a relatively high level of risk, and you can also lose money in mutual funds. Ultimately, the returns depend on the investments you choose and what happens with the markets and the economy while you're investing.

The amount you earn from an annuity, on the other hand, depends on other factors.

• With a fixed annuity, you receive a specific guaranteed interest rate that's defined in advance.
• With variable annuities, you choose from a variety of subaccounts that are invested in the market, similar to mutual funds. Earnings are uncertain—much of it depends on how the subaccounts perform. So again, you have the possibility of losses or gains depending on market performance.

With both mutual funds and annuities, you can often choose your risk tolerance. For example, you might pick relatively low-risk mutual funds or variable annuity subaccounts, or pursue higher-risk strategies when electing your investment options. However, mutual funds and variable annuities can lose money. Only fixed annuities provide protection of principal and a guaranteed interest rate.

With an annuity, you have the option to elect a guaranteed income that lasts the rest of your life (and your spouse's life, if you choose) or for a specific time period. The insurance company then takes the annuity's value and converts it to guaranteed income payments, and the payments don't go down based on how the stock market performs.

Comparatively, mutual funds do not have retirement income features. Instead, income is generated through dividend and capital gain distributions as well as any shares you sell to generate cash. Since these are all impacted by the fund’s performance and fluctuations in the market, your success depends on things like market risk, timing and other factors that are impossible to predict. When taking income from a mutual fund, it's possible to run out of money if the investment performance doesn't support your withdrawals. Likewise, if you have especially good returns, you could have a substantial amount left over at the end of your life.

Mutual funds and annuities are both long-term investments, but it can be beneficial to understand the liquidity and when you can get your money out if plans change.

With mutual funds, you can generally sell your holdings on any day that the markets are open for trading. The amount you receive depends on how the fund has performed since your purchase. Some mutual funds have additional restrictions, so be sure to research your holdings before buying or selling.

Meanwhile, deferred annuities often allow you to withdraw funds at any time. However, the insurance company may assess a surrender charge if the money has not met a specified holding period. A surrender charge period is typically for a number of years.

Many contracts allow you to withdraw up to 10% each year free of any surrender charges, so you might only pay surrender charges on the amount that exceeds your "free" amount. Just remember that variable annuity subaccounts are invested in the market. This means that the value of your variable annuity withdrawals is impacted by how the subaccounts have performed.

Before requesting a withdrawal from an annuity, get familiar with your product's features and guarantees. For instance, if your contract includes a lifetime income guarantee or similar riders, excess withdrawals can reduce the amount of guaranteed income available to you in future years.

Mutual funds have an annual expense ratio that pays for operations and management. You might also pay sales charges or other fees associated with investing, and the costs you pay are deducted from fund assets.

Alternatively, an annuity's costs depend on the type of annuity you select. Any deferred annuity can include surrender charges. Plus, when you use a variable annuity, you may also pay mortality and expense charges, administrative fees and the investment options in the contract might have their own underlying fees. It's important to also note that if you choose to add optional riders—which might offer additional guarantees or features—you may pay additional costs.

• You're looking for reliable retirement income. If you seek guaranteed income in retirement, annuities may be a good option for you. They can be especially helpful when you don't want to worry about the markets or manage investments yourself.

• You are looking for tax-deferral. Annuities also offer the potential for growth. Earnings are typically tax-deferred, so you can shelter any gains until you take withdrawals, which might be valuable during years when you have a high income.

• You're willing to take on more market risk for the potential of higher returns rather than guarantees. If your primary goal is to pursue growth over the long-term without guarantees, mutual funds might be appropriate. If you're willing to tolerate ups and downs in the markets, mutual funds can potentially help you maximize growth and manage costs. However, your funds might not grow as expected, and you might lose money—it depends on what happens in the markets.