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A variable annuity is an insurance contract that invests in market-based subaccounts and grows tax-deferred. It may offer features like lifetime income guarantees or death benefits. These features come with higher fees, possible surrender charges, and withdrawals taxed as ordinary income. A mutual fund is usually lower-cost, liquid, and easy to hold in brokerage or retirement accounts. It does not provide insurance guarantees and can generate taxable dividends and capital gains each year in taxable accounts. A financial advisor can help you compare these options and decide which better fits your goals.
How Annuities Work
An annuity is a contract with an insurance company. Annuities turn savings into guaranteed income for a set period or for life. You pay a lump sum or series of premiums, and the insurer credits interest or investment returns. Later, the insurer pays you according to the terms you choose.
Most annuities have an accumulation phase, when your money grows tax-deferred, and a payout phase, when you take income. Immediate annuities skip the build-up and start payments within 12 months, while deferred annuities start income later, often in retirement.
An annuity will work differently based on the type that you pick: Fixed annuities credit a set rate declared by the insurer; indexed annuities tie interest to a market index with caps, participation rates, and typically a floor that protects against index losses; variable annuities invest in sub-accounts whose values can rise or fall with the market.
You can fund an annuity with qualified (pre-tax) or non-qualified (after-tax) dollars. When it’s time to take money, you can annuitize for guaranteed payments such as life only, period certain, or joint and survivor. Another option is to take systematic withdrawals. Some contracts also include death benefits or optional riders that guarantee lifetime withdrawals.
How Mutual Funds Work
A mutual fund pools assets from many investors to build a diversified portfolio of stocks, bonds, or other securities. Each fund operates under a defined mandate such as growth, income, or index replication, which is outlined in its prospectus. By holding a broad mix of securities, the fund reduces exposure to risks tied to any single investment.
A portfolio manager and research team select and monitor investments, rebalance the portfolio and manage risk. Active funds aim to outperform a benchmark, while index funds seek to match a market index at low cost. Your returns reflect the fund’s results after fees. When you buy or sell fund shares, your price is the net asset value (NAV) calculated once daily after the market closes. Orders placed during the day execute at the next NAV, so there’s no intraday trading. NAV equals the fund’s assets minus liabilities, divided by shares outstanding.
Funds pass through dividends, interest and capital gains, which you can take in cash or reinvest. In taxable accounts, you may owe taxes on distributions in the year they’re paid, even if you reinvest them. Qualified dividends and long-term capital gains may get favorable rates. Tax-advantaged accounts can defer or eliminate taxes.
Major Differences of Annuities and Mutual Funds
To choose between annuities and mutual funds you must first understand their structure, how you access your money and how the IRS will tax you. Here are six differences to keep in mind:
- Purpose and structure: Insurance companies design annuity contracts to provide guaranteed income or principal protection, depending on type (fixed, indexed, variable, immediate). Mutual funds are pooled investment vehicles and do not provide guaranteed returns.
- Risk and return profile: Fixed and indexed annuities can limit downside (subject to insurer guarantees) but cap upside through declared rates, caps, or spreads. Mutual funds fully participate in market gains and losses, and there is no insurer to cushion returns.
- Fees and charges: Annuities often include surrender charges, mortality and expense (M&E) fees, administrative costs, and optional rider fees. Mutual funds charge expense ratios, and costs are typically transparent and easier to compare.
- Liquidity and access: Annuities commonly have multi-year surrender periods and free-withdrawal limits. Withdrawals before age 59½ can also incur a 10% IRS penalty. You can buy or sell mutual funds on any business day at net asset value. Some funds may impose short-term redemption fees fees.
- Taxes and timing: Annuity growth is tax-deferred. Earnings are taxed as ordinary income when withdrawn, and non-qualified contracts generally follow earnings-first (LIFO) treatment. Mutual funds pass through dividends and capital gains annually in taxable accounts, and these are often taxed at capital gains rates.
- Guarantees and oversight: Annuity guarantees depend on the issuing insurer’s claims-paying ability. State insurance departments oversee the contracts to ensure compliance with laws and regulations. The SEC regulates mutual funds. They offer no guarantees, and market risk remains with the investor.
How to Choose the Right Investment for Retirement
Before comparing products, get clear on what you want your money to do. Are you aiming to maximize long-term growth, secure reliable income you can’t outlive, or preserve principal for heirs? Your primary goal will narrow the field and dictate the trade-offs you can accept.
As you weigh variable annuity vs. mutual fund choices, decide whether guaranteed income is a must-have or a nice-to-have. Variable annuities can convert savings into a predictable income stream through annuitization or optional riders, while mutual funds are built for market growth and flexible withdrawals without guarantees. If income certainty matters more than upside, an annuity may fit. If flexibility and lower costs matter most, funds often lead.
Your risk tolerance and time horizon should guide how much market volatility you take on. If you’re decades from retirement, diversified stock mutual funds may offer efficient compounding. Near or in retirement, blending growth assets with an annuity-based income floor can help manage sequence-of-returns risk.
Model different market scenarios, income start dates and longevity assumptions to see how each option performs. A fiduciary financial advisor can help compare after-fee, after-tax outcomes, evaluate insurer strength for annuity guarantees and build a mix that aligns with your goals.
Bottom Line
Variable annuities grow tax-deferred and can include income or death benefit guarantees. These features come with higher costs, surrender charges and ordinary income taxes on withdrawals. Taking money out before age 59½ can also trigger a 10% penalty. Mutual funds are simpler, more liquid and lower cost. They create taxable events when they pay distributions or when you sell shares. In taxable accounts, long-term gains and qualified dividends may get lower tax rates. Mutual funds do not provide guarantees against market losses.
Investment Planning Tips
- A financial advisor can help you create a plan to manage both investments and risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to diversify your portfolio, here’s a roundup of 13 investments to consider.
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