Key Takeaways
- Annuities provide steady retirement income with some growth.
- Mutual funds pool money for investing in securities like bonds and stocks.
- Annuities may have higher fees than mutual funds. Mutual funds generally lack tax-deferred growth.
- Annuities and mutual funds have different features. Whichever is best for you depends on your goals and time horizon.
What Is an Annuity?
An annuity is a contract between an individual and an insurance company. Annuities are designed to provide a guaranteed income stream during a person’s retirement years, often for the contract holder’s lifetime, and have the added benefit of nominal growth as compared with equity investments.
The customizable nature of annuities makes them ideal for people who have specific retirement and estate planning goals.
In addition, the tax treatment of annuities appeals to people who want to defer taxes until they reach the age at which they will begin taking distributions.
Whether deferred or immediate, annuities offer flexibility. Annuitants can reap the benefits of fixed rates or — if they’re comfortable with a less stable return — develop a strategy to take advantage of market gains.
Pros and Cons of Annuities
Annuities are highly customizable insurance products that can create a reliable income stream. Annuities come with their own set of advantages and disadvantages that can make them more or less suitable depending on your financial goals and circumstances.
“The main attraction and advantage of an annuity is that it serves as a source of tax-deferred and predictable income for individuals in their retirement,” Mark Stewart, a CPA at Step By Step Business, told Annuity.org.
Another reason for buying an annuity is the ability to leave a legacy to your heirs. By purchasing an annuity with a death benefit and naming a beneficiary, you can leave assets to your heirs without the funds having to pass through probate.
Yet annuities are not for everyone. Their lack of liquidity might not appeal to some investors, they are designed to be long-term vehicles and withdrawing funds early can mean hefty penalties. Fees and surrender charges are also potential drawbacks and can eat into returns, though costs vary widely depending on the type of annuity and the annuity provider.
Ultimately, annuities are complicated financial instruments that can be difficult for the average person to understand. This complexity is a drawback for some investors.
Pros and Cons of Annuities
Pros
- Guaranteed income stream
- Principal protection
- Tax-deferred growth
- Customizable contracts
- Legacy for beneficiaries
Cons
- Limited liquidity
- Potentially costly fees and surrender charges
- Complex contracts
- Returns may be modest
Purchase an Annuity Today
It’s very important to consider your goals when choosing investments because different types of investments are better suited for different purposes. Annuities and mutual funds can both be good choices depending on what you want from them.
Brandon Renfro, Ph.D., CFP®, RICP®, EACo-Owner of Belonging Wealth ManagementAs a Certified Financial Planner™ professional and Retired Income Certified Professional®, Brandon Renfro is well-versed in the financial information and strategies needed to meet retirement goals. In addition to co-owning Belonging Wealth Management and assisting clients, Brandon writes regularly for financial publications.
What Is a Mutual Fund?
A mutual fund is a company that pools money from many investors to invest in a diversified portfolio of stocks, bonds or other securities. When you buy shares of a mutual fund, you are buying a portion of the mutual fund’s holdings.
Mutual funds offer instant diversification, professional management and liquidity. They also have the potential for higher returns compared to fixed annuities.
The SEC refers to a mutual fund as a “company” and the fund’s holdings as a “portfolio.” This differentiation is significant and can be a source of confusion for novice investors.
The performance of a mutual fund is measured by the increase or decrease in the total market value of the fund’s shares. Profits from mutual funds are realized as dividends and interest (income distributions) or as sales of fund shares (capital gains distributions).
Read More: How To Diversify Your Portfolio
Pros and Cons of Mutual Funds
Investing in mutual funds can be a reliable way to diversify your portfolio, as mutual fund shares are invested in the portfolio of different securities the fund holds.
“Mutual funds are a secure form of investment that is highly liquid and low risk,” said Stewart.
However, investing in mutual funds involves market risk. Other drawbacks of mutual funds include that you can’t control how the fund invests your money and that the yields tend to be low, according to Stewart.
Pros and Cons of Mutual Funds
Pros
- Diversification
- Liquidity
- Flexibility
- Professional investment management
Cons
- Low yields
- Little control
- Risk of losing principal investment
- Can carry a range of fees
Comparing Annuities and Mutual Funds
Annuities and mutual funds each have a place in saving and investing. Many times, however, one may be a better fit than the other. Your risk tolerance and your retirement timeline should determine whether an annuity or a mutual fund best fits into your financial plan.
When comparing annuities and mutual funds, several factors come into play. Always consult with a financial advisor before making a decision.
Taxation
Annuities and mutual funds are taxed differently. As mentioned, the tax-deferred growth of an annuity is one of the biggest benefits of the product. Annuity owners don’t pay taxes until they start receiving money from their annuity, which can be especially beneficial for individuals in higher tax brackets.
If the annuity is part of a qualified retirement plan like a 401(k) or IRA, all the money withdrawn or distributed is taxable. But most annuities are non-qualified, meaning they were funded with after-tax money and the payments from these kinds of annuities are only partially taxed as income.
Unlike annuities, mutual funds do not grow tax-deferred unless they are held within a qualified retirement plan. Any distributions are subject to taxes when they are received, and you’ll pay capital gains taxes if you sell at a profit.
However, taxable mutual funds do enjoy a “stepped-up” basis at death for tax purposes. This means that when a mutual fund holder passes away, the person who inherits the mutual fund holdings will not owe tax on the inheritance.
Rates of Return
It can be difficult to compare the returns of annuities and mutual funds because there exist many types of annuities, each with different rates of return.
Some annuities have very similar returns to mutual funds. Variable annuities, for example, are invested in a portfolio of underlying assets and their growth is tied to the performance of those investments. These returns are not guaranteed and can fluctuate with market conditions.
Fixed annuities, on the other hand, accumulate interest according to a guaranteed rate set when the contract begins. These returns are predictable, unlike the returns of mutual funds. But mutual funds offer potentially higher returns than fixed annuities can, especially if they are invested in stocks or other high-growth assets.
Annuity holders receive their returns as a series of regular payments or, in many cases, as a lump sum when they become eligible to cash in their annuity.
In contrast, according to FINRA, mutual funds give you the option of receiving “distributions in cash or having them automatically reinvested in the fund to increase the number of shares you own.”
Costs
Mutual funds and annuities are both subject to fees and charges required to maintain the accounts.
Typical mutual funds charge annual fees called expense ratios. Some may charge commission fees.
Annuity fees depend on the type of annuity you have. Fixed annuities, for example, usually have no annual expenses or custodial fees. They may be subject to maintenance fees, and annuity owners may have to pay surrender charges or market value adjustments if they withdraw funds from the annuity prematurely.
Variable annuities carry additional fees ranging from subaccount charges to mortality and expense fees, as well as surrender charges and maintenance fees.
In general, annuities carry more costs than mutual funds.
Liquidity
Mutual funds are generally much more liquid than annuities.
You can sell your mutual fund shares at any time. And, unless your mutual fund is held within a qualified retirement plan, early withdrawals from the account won’t be subject to IRS penalties.
Annuities, on the other hand, are designed to be long-term investments. As a result, it’s difficult to withdraw funds from an annuity before the contract annuitizes and payments begin without facing hefty surrender charges. The IRS also levies a 10% penalty on any withdrawals made before you turn 59 ½.
Depending on the terms of your contract, you may be able to withdraw a small percentage of your contract’s value each year without paying a surrender charge.
Can You Retire Comfortably?
Frequently Asked Questions About Annuities and Mutual Funds
In terms of guaranteed retirement income, fixed annuities may be safer than some other types of investments, including mutual funds. Annuities can guarantee a retirement income at a fixed rate, while the return on mutual funds varies with underlying investment performance.
Annuities are tax-deferred, meaning you don’t pay income taxes until you withdraw money from your annuity. Mutual funds do not grow tax-deferred unless they are part of a qualified retirement plan.
The rate of return with a fixed annuity may be lower than that of a mutual fund, but a fixed annuity rate is guaranteed and predictable. Mutual fund returns, however, depend on how well underlying investments perform and are less predictable.
Annuities and mutual funds can be used together to bolster your retirement savings, and one isn’t necessarily better than the other for retirement income. A financial professional can guide you to the appropriate investment product based on your risk tolerance and long-term plan.
