Annuities Versus Mutual Funds: What’s Best For Retirement Planning?

An annuity, a long-term contract between a buyer and an insurance company that allows the accumulation of funds on a tax-deferred basis for later payout in the form of a guaranteed income, can be part of a retirement plan, as discussed in last month’s article, “Do Annuities Have A Role In Retirement Planning?

However, it is important to weigh the advantages and disadvantages of owning an annuity against other investment options for retirement, such as mutual funds.

Before investing, one should compare the annuity fee structure with regular no-load mutual funds. No-load mutual funds levy no sales commission or surrender charge and impose average annual expenses of less than 0.5% for index funds or around 1.5% for actively managed funds.

It’s also important to consider that earnings from an annuity will be taxed as ordinary income when the earnings are withdrawn, no matter how long the policyholder has owned the account.

The scenarios discussed in this article apply in the United States. Readers are encouraged to consult their accountants about tax considerations related to buying annuities.

Annuities’ Advantages

Annuities do have some important advantages over other investments in retirement planning. Payouts can be guaranteed for life, regardless of how much the account actually earns, and they often include a guaranteed death benefit.

Income from stocks and mutual funds is not guaranteed, and there is no death benefit.

With mutual funds, the investor pays in an amount that is invested in a number of stocks, bonds, or a mixture of both, to create a stream of retirement income from stock dividends and bond interest.

While mutual funds use investment diversity to limit market risk, this is not a guarantee, according to Howard Kaye of Howard Kaye Insurance. Earnings can fluctuate significantly, and it is possible that no dividends or earnings will be paid out, especially if the principal is reduced.

Annuities have other advantages as well.

Unlike investments in tax-deferred retirement accounts, there is no limit on the amount that can be invested tax-deferred in an annuity, unless it is held inside a tax-deferred account, such as an IRA or a 401(k).

Variable annuities offer the opportunity to earn more than the guaranteed payment, depending on the performance of the investments. A variable annuity is essentially a mutual fund inside of a tax-deferred insurance policy, according to Trust Point, a Wisconsin based wealth management firm. Investments are made within mutual funds or mutual-fund-type accounts offered by the particular annuity, and the earnings grow tax deferred until they’re withdrawn.

Variable annuity investors can also switch from one investment to another within the annuity’s menu of choices without paying taxes. A mutual fund investor cannot switch among taxable mutual funds. Hence, annuity investors have more flexibility in adjusting their portfolios.

Annuities’ Disadvantages

Annuities are not without their disadvantages, however.

The earnings from an annuity, when withdrawn, are subject to the ordinary income tax rate, which for many is higher than the long-term capital gains rate that one incurs in owning a mutual fund, according to Daniel Kurt, writing in Investopedia.

If you buy a qualified annuity – that is, one you purchase with pretax dollars – you’ll have to pay ordinary income taxes on 100% of the disbursements you receive, Kurt noted. With a non-qualified annuity, some of the payment is considered a tax-free return of principal; only the earnings portion is subject to tax.

Stock dividends, by contrast, will be taxed at the capital gains rate rather than as ordinary income.

Trust Point offers the example of someone in a high-ticket tax bracket, who pays 39.6% on gains when they withdraw their money from their variable annuity, instead of the lower 15% or 20% long-term capital gains rates. This will be true regardless of whether the withdrawn dollars are a result of income dividends or capital gains distributions.

In addition, variable annuities can hit the policyholders’ heirs with a big unexpected income tax bill. If a $25,000 investment grows to $100,000 over the years and the policyholder dies, their heirs will owe income taxes on $75,000. If the policyholder is in a lower tax bracket than their heirs, it might make sense for a retiree to take distributions before death if there are no surrender charges.

In contrast, if they owned taxable mutual funds or other securities, the heirs would not have to pay taxes on the $75,000 in gains because taxable mutual funds enjoy a “stepped-up” basis at death for tax purposes, Trust Point noted.

The tax treatment of annuities is one reason why Kurt encourages people to buy as much income protection as needed – that is, expenses minus whatever they receive from Social Security or a pension. That way, you can invest the rest of your assets in an account that benefits from the capital gains rate.

The income guarantees of variable annuities add an expense that can clip the total return earned by the variable annuity investor, according to Trust Point.

As with mutual funds, payments from variable annuities fluctuate up or down depending on the performance of the underlying investments.

Fixed Indexed Annuities

Another choice investors have is the fixed indexed annuity. These annuities use financial indexes as a benchmark for earnings. The funds in the annuity are not directly invested in the stock market. Instead, the earnings are based on the earnings within an index, such as S&P 500, Dow Jones Industrial Average, etc.

(A fixed indexed annuity should not be confused with a fixed annuity, which provides a fixed amount every month for the rest of the annuitant’s life.)

While fixed indexed annuities use stock market indexes as benchmarks for earnings, the investor’s funds are not directly invested in the stock market. Instead, the earnings are based on the earnings within an index.

Like variable annuities, fixed index annuities have both advantages and disadvantages compared to mutual funds and other investments.

While they offer a market-risk-free opportunity, fixed indexed annuities aren’t as liquid as cash, noted Kaye of Howard Kay Insurance.

They are, however, more liquid than most CDs or bonds, Kaye noted. In fact, nearly all offer “free withdrawals” every year. Once the surrender period is over, all of the funds are fully liquid.

Should the policy holder die during the annuity period, it’s possible that there won’t be much left for heirs. Such products are best suited for someone looking to supplement income and already has an estate plan in place for their heirs.

The decision of whether to invest in a variable annuity, fixed indexed annuity or a taxable mutual fund will depend on individual factors such as age, expected lifetime, the reason for the investment, liquidity needs, fees, estate plan and the overall portfolio.

Featured image courtesy of Shutterstock.

Author:
Lester Coleman is a veteran business journalist based in the United States. He has covered the payments industry for several years and is available for writing assignments.

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