As you approach retirement, you have to make important decisions about managing your
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.
What to know: Annuities vs. mutual funds
5 key differences between annuities & mutual funds
1. They are taxed differently
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.
Bottom line: Annuities are tax-deferred and are taxed at ordinary income rates upon distribution. Mutual funds may have annual taxable distributions of capital gains and dividends, as well as generating capital gains when you sell the mutual funds.
2. The rates of return are often different
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
With both mutual funds and annuities, you can often choose your
Bottom line: Mutual funds and variable annuities may provide higher rates of return over the long-run, depending on market performance. In addition, mutual funds may provide higher rates of return over the long run than a variable annuity. This is due to the additional cost of a variable annuity that provides insurance features, such as a death benefit and annuity payout options.
3. Only annuities are specifically designed for guaranteed retirement income
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.
Bottom line: Annuities are designed to provide guaranteed income while mutual funds do not have specific retirement income features.
4. The liquidity varies
Mutual funds and annuities are both long-term investments, but it can be beneficial to know how 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.
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. Recall 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.
Bottom line: Mutual funds have greater liquidity than annuities.
5. Annuities are generally more expensive—for good reason
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.
Bottom line: Annuities have built-in guarantees which typically make the expenses higher than you will find with mutual funds.
When annuities may make sense for you
- 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.
When mutual funds may make sense for you
- 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.
Which is "best" depends on what you value
In an annuity vs. mutual fund comparison, you'll find they're both powerful tools for
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