Annuities and mutual funds are investment products that can potentially provide you with long-term growth and supplemental income. Both product types involve certain fees and some exposure to the securities markets. Despite the broad similarities, there are many differences between mutual funds and annuities that include tax considerations and liquidity.
Mutual funds are investment portfolios that contain thousands of other securities such as bonds, stocks and even shares in other mutual funds. The value of a fund and its shares depends entirely on the performance of the underlying securities. Some funds containing mostly bonds are designed to generate income while stock funds are designed to grow. However, there are no principal guarantees so your shares could rise or fall in value. Annuities are insurance contracts that include certain lifetime income benefits. You pay a premium to buy a contract and in return you receive either an immediate or a deferred income stream. Some annuities also include death benefits that assure your beneficiaries of a payout if you die.
You can sell mutual fund shares at any time. Trades are executed at the close of the stock market once the closing values of the underlying securities have been calculated. It usually takes a few days for the fund to disburse your proceeds. Immediate annuities are illiquid because you cannot get a return of principal once your monthly income payments have commenced. With a deferred annuity, your funds are invested for a set number of years and are generally inaccessible during this term, although some contracts include provisions for small annual withdrawals. At the end of this term the contract converts your cash into a monthly income stream.
Dividends on mutual funds are subject to income tax, while profits generated from the sale of mutual funds are subject to capital gains tax. Shares sold within one year of the purchase date are taxed at the short-term capital gains rate which is the same as your regular income tax rate. Shares held longer than a year are taxed at the long-term gains rate, which as of 2012 amounts to just 15 percent. Annuities are afforded the same kind of tax treatment as retirement accounts. Your premiums and earnings grow tax deferred. Withdrawals of earnings and pre-tax contributions are taxable. You must also pay a 10 percent tax penalty pre-tax annuity contributions and earnings that you withdraw prior to reaching age 59 1/2.
Mutual fund companies often charge sales commissions, known as loads, that you pay either when you buy or sell shares. Additionally, funds charge fees to cover annual operating expenses and these charges are deducted from your holdings. Loads are often as high as 5 percent while annual operating fees usually range between 1 and 2 percent. On annuities there are no upfront fees, but some deferred annuities include annual operating fees that in part cover costs associated with underlying mutual funds. These fees often amount to 2 or 3 percent of your contract's value. Additionally, you may pay surrender fees of 8 percent or more if you cash in a contract before it matures.
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