Variable annuities and mutual funds contain many identical features that can make the two products difficult for inexperienced investors to distinguish. If you are considering investing in an annuity or mutual funds, you must learn the differences between them and understand how each product may impact your financial situation.
Variable annuities are purchased directly from life insurance companies. Regardless of whether your annuity is qualified or non-qualified, the insurance company will be the account custodian. Mutual funds can be purchased directly from the fund company or through selling agreements with a brokerage firm. No difference exists between mutual funds purchased directly or through your broker's affiliation.
Since variable annuities are retirement investment vehicles, earnings remain tax-deferred until they are withdrawn. If your annuity is designated as an IRA, distributions are included in your taxable income and subject to ordinary income tax rates. Non-qualified annuities still accumulate tax-deferred earnings, but only the growth is taxable. You can purchase mutual funds in an IRA and distributions are fully taxable at ordinary income tax rates. However, unlike annuities, mutual funds not purchased in an IRA do not accumulate tax-deferred and are instead subject to capital gains taxes each year,.
The investment options within variable annuities are called sub-accounts. Most variable annuities offer owners 10 to 20 options to diversify their savings. The majority of sub-accounts are clones of popular mutual funds, and are even managed by the same teams of professionals overseeing the identically named mutual funds. Regarding performance, these sub-accounts and their mutual fund doppelgangers typically report almost the same earnings or losses and any discrepancy is minuscule.
Mutual fund purchases are subject to sales charges based on the class of shares bought. Class A shares carry an upfront fee of approximately 5.75 percent. This fee is typically reduced for larger purchases exceeding pre-determined thresholds. Class B shares carry a back-end fee of 5 percent. This fee is not deducted from your initial investment but is instead withheld when your shares are sold. Class C shares typically do not carry an upfront or back-end sales charge unless shares are sold within one year of purchase. Despite being clones of popular mutual funds, variable annuity sub-accounts are not subject to these sales charges. However, both mutual funds and sub-accounts pay service charges called 12b-1 fees. These fees cover a variety of expenses including printing and mailing prospectuses, marketing, advertising and broker commissions. The 12b-1 fees typically range from 0.5 to 1.25 percent. Variable annuities also contain administration charges called "mortality and expense" fees, which are deducted from your account annually and intended to protect the integrity of your portfolio. M&E charges commonly range from 0.5 to 2.0 percent.
Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.