When it comes to annuities vs. mutual funds, Americans—particularly retirees—have historically been buyers of variable annuities. But lower tax rates on profits from the sale of investments have resurrected an old debate: are taxable mutual funds a better investment for accumulated savings than variable annuities?
Lower capital gains tax rates certainly make many taxable mutual funds more attractive. But, are variable annuities still a suitable option for some investors seeking retirement income? Let’s take a look.
Annuity vs Mutual Funds: What’s The Difference?
Before reading, make sure to check out this helpful breakdown of annuities vs. mutual funds to better understand the differences between each.
What is a Variable Annuity?
A variable annuity is basically a mutual fund inside a tax-deferred insurance wrapper. Investments are made in mutual funds or mutual-fund-type accounts offered by the particular annuity. The investments are not tax-deductible since usually variable annuities are sold outside tax-deferred accounts as they already have a tax-deferred component. Then the earnings grow tax-deferred until they’re withdrawn, usually at retirement. Payouts from variable annuities can be guaranteed for life, regardless of how much the account actually earns, and there can be a death benefit guarantee. But payments may fluctuate up or down depending on investment performance of the underlying investments.
The catch is that these guarantees add to the expense of variable annuities when compared with mutual funds. This drags on the total return earned by the variable annuity investor. Investors should first take advantage of other tax-deferred retirement vehicles that generally have lower expenses and deductible contributions before considering variable annuities.
Also, annuities have a couple of little-noticed tax drawbacks for both the annuity owner and their heirs. How can this be? After all, the enormous appeal of variable annuities is that your money grows tax-deferred until you take it out. That’s true. But when you take it out, the money is taxed as ordinary income rather than at more favorable tax rates for capital gains and qualified dividends.
For example, if you’re in the big-ticket tax bracket, you’ll be paying 39.6% on gains when you withdraw your money, instead of the lower 15% or 20% long-term capital gains rates. And that will be true regardless of whether the withdrawn dollars result from income dividends or capital gains distributions.
Finally, variable annuities can hit your heirs with a big unexpected income tax bill. How so? Say you invest $25,000 that grows to $100,000 over the years, and then you die. Your heirs will owe income taxes on $75,000 at their tax rate, which is often higher. If you are in a lower tax bracket than your heirs, it might make sense for you to take the distributions before death if there are no surrender charges.
What About Taxable Mutual Funds?
In contrast, if you owned taxable mutual funds or other securities, your heirs would not have to pay a penny of taxes on the $75,000 in gains. That’s because taxable mutual funds enjoy a “stepped-up” basis at death for tax purposes. It’s one of the few bona fide tax loopholes around.
Here are a few reasons that investors may still find variable annuities attractive:
- Unlike investments in tax-deferred accounts, there is no limit to the dollar amount that can be invested tax-deferred in a variable annuity (unless it, too, is held inside a tax-deferred account).
- Not all investors, especially older ones, invest primarily in stocks or other investments that generate capital gains. For example, investors preferring bonds will find their after-tax income closer to variable annuity investments because interest income is taxable at ordinary income tax rates, just as it is with variable annuity withdrawals.
- Annuity investors can switch from one investment to another within the annuity’s menu of choices without paying taxes. Investors cannot make a similar switch among taxable mutual funds. This allows annuity investors more flexibility in adjusting their portfolios.
Ultimately, the decision of whether to invest in a variable annuity or a taxable mutual fund will depend on the investor’s personal situation: age and expected lifetime, the reason for the investment, liquidity needs, fees, estate plan, and their overall portfolio. The best idea is to contact the professionals at Trust Point, review your individual circumstances, and make some sound financial decisions that will help you reach your financial goals.
Traditionally, investors are sold the idea that annuities are a safe and secure way to receive retirement income. But there should be a “buyer beware notice” when considering if an annuity is appropriate for an investment portfolio.
There are significant investment expenses and varying taxes and estate implications when considering annuities versus a diversified portfolio of mutual funds. Therefore, it is essential to work with professionals held to a fiduciary standard, such as one of the Certified Financial Planner™ professionals at Trust Point, when deciding whether an annuity or mutual fund is appropriate.
To help demystify these options, here’s a breakdown of each:
Are Annuities Right For Me?
When considering annuities, the investor should first learn and understand the costs of purchasing annuities as part of their overall investment portfolio. There are multiple layers to the cost structure of annuities as these costs include commission charged at the purchase of the annuity, annual expenses, surrender charges, and tax implications. In addition to financial costs, there are also opportunity costs associated with the impact on the estate plan’s beneficiaries.
Since annuities are products that are most often sold by insurance companies, they often have high commission charges. These commission charges can be as high as 10 percent of the original investment. Additional annual expenses known as mortality expense and administrative fees are also included. These annual expenses, which are often combined with the riders (attached benefits for specific needs?), can equal between 2–3 percent annually. The additional rider charges are often necessary expenses so that investors can receive guaranteed payouts, principal protection, increased payouts, etc.
Annuities also have surrender periods and corresponding surrender charges. Typically these surrender periods are between five and seven years, or even longer for some annuity contracts. The surrender charge is often reduced the further a surrender period extends. A caveat to the charges is that most annuities allow the investor to draw up to 10 percent annually without paying surrender charges. However, if the annuity owner needs to take a large distribution during this period, they may be obligated to pay the corresponding surrender charge in addition to any potential tax liabilities.
Taxes and Penalties
Taxes and early distribution penalties are additional costs associated with annuities. Since annuities are tax-deferred vehicles (assuming they are held outside an IRA), the investment earnings will be taxed as ordinary income. When an annuity is held within an IRA, distributions are fully taxable as ordinary income.
Lastly, for distributions from non-qualified annuities before age 59 ½, there is a 10 percent early withdrawal penalty. This penalty applies to annuities held within an IRA as well. Investors will want to be sure to contact their tax specialists when considering distribution strategies with their annuities. In addition to the higher tax rates on the investment earnings, annuity beneficiaries will miss out on the step-up in cost basis. Therefore any gains in the account will require the beneficiaries to pay taxes to receive the inherited portion of the account.
Accumulation and Distribution
The decision to use an annuity directly affects what benefit the beneficiaries named on the contract can expect to receive. With annuities, there are essentially two different phases; accumulation and distribution.
In the accumulation phase, the investor has purchased the annuity with a lump-sum contribution to grow the balance. If the annuitant dies during this phase, the designated beneficiaries will receive the annuity’s death benefit.
Once the annuitant has implemented the distribution phase, they have traded all assets of the annuity for a version of guaranteed income for life, joint life, or a certain period. This means if the annuitant passes away, the income is only guaranteed for their life, the life of a surviving beneficiary, or for a certain number of years. After the contract has been satisfied, the annuity income stream is over, so the annuitant’s beneficiaries would receive no additional benefits.
Mutual Funds Explained
Making Sense of Mutual Funds
Mutual funds are cost-effective and important pieces of a properly diversified portfolio. They are appropriate for both qualified accounts, such as an IRA, and non-qualified accounts, such as a brokerage account.
Fees associated with mutual funds should always be an important consideration. This includes the investment management fees and portfolio expenses, the fees charged by mutual funds to invest with them. Many institutions utilize an “Assets Under Management” fee schedule where fees usually begin around 1 percent of all assets.
Qualified accounts holding mutual funds enjoy tax deferral benefits until age 70 ½ if the account owner is retired. This includes all income and capital gains that are reinvested within the fund. Additionally, all trades and sales within these accounts are given the preferential tax treatment of not paying taxes on gains.
Non-qualified accounts are held to a different set of tax rules. Income and capital gains are reported on IRS Form 1099 and must be reported on the account owner’s individual or joint tax return. But capital gains are taxed at significantly lower tax rates than taxable income. For example, ordinary taxable income can range from 10 percent to 39.6 percent. Taxes on long-term capital gains range from 0 percent to a maximum of 20 percent.
As of 2023, investors with taxable income less than $83,350 will pay 0 percent on all capital gains. Investors earning between $83,351 and $517,200 will pay 15 percent tax on capital gains. An investor with an income above $517,200will pay 20 percent on capital gains. These numbers are based on married investors, filing jointly. Please consult your accountant or IRS.gov for further details, as tax rates and income limits are subject to change on an annual basis.
Mutual funds are not only an important part of a well-diversified portfolio; the IRS gives them special treatment as part of an overall estate plan.
Mutual funds held in a diversified portfolio receive a “step-up in basis” at the death of the account owner, and if the account was held jointly, they also receive a second “step-up in basis” after the second spouse dies. This means if an account owner were to invest $25,000 in a mutual fund that had grown to $150,000 over 20 years and the account owner passed away, the heirs would not have to pay a single penny of taxes on the $125,000 in growth. On the date of death, the $25,000 basis is “stepped up” to $150,000, eliminating any taxable gain. This is an incredible advantage of a mutual fund and is available to everyone.
When comparing annuities to mutual funds, there are several clear advantages for mutual funds. These include:
- No commissions or loads on mutual funds (Trust Point utilizes no-load mutual funds and does not receive any kickbacks for selecting certain funds)
- Reduced annual investment expenses
- Lower tax rates on investment gains for non-qualified accounts
- Step-up in cost basis at the owner’s death
- The beneficiary receives the account balance at the owner’s death
Ultimately, when the investor decides to consider annuities as part of their overall portfolio, they will want to research and understand the real costs of the product they are buying. Annuities may have a place and time, but often there are better and more economical investments for an investor’s overall portfolio.
Contact The Professionals At Trust Point
For a comprehensive investment and financial review, please contact one of the CFP® professionals at Trust Point.
Interested in learning more about your investment options? Contact us to start a conversation.