Mutual Funds and Annuities - Important Things Every Investor Should Know
Mutual funds and annuities can each play an important role in a financial plan. They are different types of investments designed to accomplish different financial objectives. Costs, investment control, income guarantees and tax* efficiency are important factors in evaluating these investment instruments. They are each designed to meet different needs and time horizons. While Fixed** and Equity Indexed annuities (EIA) are contracts with insurance companies, variable annuities*** are securities with special type of contracts with insurance companies. They give you the ability to invest in both fixed-income and stock market-based type of sub-accounts whose values change depending on the performance of these underlying investments. While variable annuities offer the potential for higher long-term returns than fixed annuities, generally their values will fluctuate up and down (sometimes dramatically) from year to year. Unlike with a fixed annuity, you assume all investment risk.
A mutual fund is a company that brings together money from investors and invests it in stocks, bonds or other assets. Variable annuities usually cost more than traditional mutual funds because their insurance component increases total expenses. Exchanges between mutual funds may result in capital gains while exchanges within sub-accounts of variable annuities are tax free.
If an investor invests in a variable annuity through a tax-advantaged retirement plan, the investor will realize no additional tax advantage from the variable annuity. Variable annuities appeal to tax conscious investors who presumably have taken full advantage of traditional tax-sheltered retirement plans such as IRAs and 401(k)s and are seeking another tax-deferral avenue. Pluses include the fact that there are no contribution limits and annuity holders are not required to begin taking distributions at age 70½. The IRS requires that individuals who are 70 1/2 and older take Required Minimum Distributions (RMD) from all qualified plans Including Traditional IRA, 401K and 403b. Qualified plans are those established with pre-tax funds and for which earnings have received tax deferral during the accumulation phase.
Fixed and equity indexed annuities also appeal to investors with low risk tolerance due to their potential higher levels of protections against investment losses.
While mutual funds don’t offer guaranteed income for life, annuities offer different options for receiving income, which can include two-life annuities, which ensure the annuity income will last for you and your annuity partner’s lifetime, or a guaranteed period, which continues payments to your beneficiary(ies) for the rest of a set period if you and your annuity partner die within the guaranteed period. Because they offer these options, average expense ratios for annuities are typically higher than mutual funds.
While annuities are tax-deferred until withdrawn (IRS considers that variable annuities’ earnings are withdrawn first and therefore subject to taxation and treated as ordinary income-the reminder is not taxed), mutual funds’ dividends and distributed capital gains are taxed in the year received. Unrealized capital gains (share price appreciation) are tax deferred.
Current tax laws allow heirs to receive a ‘step-up’ in cost basis for any stock or mutual funds you leave them when you die. This eliminates capital gains tax on any gains on those investments from the time they were purchased. In other words, any taxes paid by your beneficiaries would be based on prices at the time of death rather than the original purchase price. An annuity does not receive a stepped-up basis, and beneficiaries pay ordinary income tax rates on any payouts based on original purchase values.
With the exception of mutual funds held in Transfer on Death (TOD) accounts, other mutual fund accounts don’t avoid probate court proceedings. Annuities avoid the probate if beneficiary named is other than estate.
As you plan your retirement income, you want to carefully consider your options and implement strategies that provide solutions to your unique financial situation. I will be happy to help you in your decision-making process.
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* It is not the intent of Dee Turkalj to provide tax advice. Gold Coast Securities, Inc, its affiliates and agents are not in the business of providing tax advice. Please contact your tax advisor with all questions regarding how anything discussed above may affect your tax situation
** The guaranteed rate of return is secured by the general assets of the insurance company. Investors should consider the financial strength of the insurance company that sponsors the annuity. This can affect the insurance company’s ability to pay claims.
*** Investors should carefully consider the financial strength of the insurance company that sponsors the variable annuity. This can affect the insurance company’s ability to pay claims beyond the value of your account in the investment options, such as the death benefit. Investors should note that variable annuities are suitable for long-term investors only. Variable annuities are not suitable for short-term investment goals as substantial taxes and insurance company charges may apply if you withdraw your money early from the variable annuity. Variable annuities involve investment risk and will fluctuate in value.