Which is Better For Retirement: Annuity or Mutual Fund?

Annuities and mutual funds are two of the common choices of investments for many retirees. There are upsides and downsides associated with investing in either of these options, as is the case with all financial products.

If you are someone who is about to retire, does it make more sense for you to invest in a mutual fund? Or is an annuity a better investment option for you? Let us find out.

An annuity is essentially a contract between you and an insurance provider, wherein you invest a sum of money — either in the form of a lump sum or through a series of payments — and receive guaranteed income in return, either for a set period of time or for the rest of your life. Depending on the type of annuity you invest in, the payments could start immediately or after a period of time.

Annuities can be generally categorized into two types based on their potential rate of return: fixed annuities and variable annuities.

  • A fixed annuity, as the name indicates, provides you with a guaranteed income for the duration of the contract. The payout is predetermined and does not increase or decrease, irrespective of how the market performs.
  • The returns on a variable annuity, on the other hand, are not guaranteed. The payouts could increase or decrease depending on how the market performs.

What is a mutual fund?

A mutual fund is a financial product which collects money from investors and makes investments on their behalf.

The money is invested in a variety of different securities like stocks, bonds, and money market instruments. You can invest in a mutual fund through a brokerage account, a 401(k) account, or an individual retirement account (IRA).

Mutual fund portfolios are run by investment professionals who are tasked with the responsibility of producing income and capital gains for the investors on a consistent basis.

Mutual funds can be classified into several types based on the securities they invest in. Equity funds, for instance, only invest in stocks. Index funds, on the other hand, mimic the investment pattern of a market index, as a result of which their rate of growth is also directly linked to the performance of the index.

Similarly, you can also invest in exchange-traded funds (which can be bought and sold on stock exchanges), money market funds (which invest in debt instruments), fixed income funds (which invest in bonds), balanced funds (which invest in stocks as well as bonds), sector funds (which invest only in a specific sector), and global funds (which make investments around the world).

It is essential to consider the following factors before choosing to invest your money in an annuity or a mutual fund.

This is a key factor which needs to be considered, especially if you do not have a stable source of income to rely on during your retirement years.

Fixed annuities are the best bet for anyone who is need of a stable and guaranteed source of income. The insurance company pays you a specific amount of money — in the form of monthly, quarterly, or yearly payments — throughout the contract period, regardless of the market conditions.

Variable annuities, as mentioned above, do not have a guaranteed rate of return, as a result of which the payments could increase or decrease from time to time. Some variable annuities, however, have a minimum rate of return, which is guaranteed by the insurance company.

No matter how bad the market conditions are, you will not receive less than the minimum guaranteed payment.

Mutual funds, on the other hands, do not provide you with a guaranteed income. The returns on your investment could vary greatly depending on how the market performs.

Expenses

The expenses associated with annuities are higher than that of most other investment products. Mutual funds, on the other hand, have very low expenses. The expenses on index funds, in particular, can be as low as 0.10%.

Taxation

The income from annuities grows on a tax-deferred basis until you withdraw it. When you withdraw or cash out your annuity, any income above the original investment you made is taxable. You will be taxed according to the income tax bracket that you belong to.

With mutual funds, you have to pay taxes on dividends, capital gains, and capital gain distributions. If you, however, invest in a mutual fund through a 401(k) account or an individual retirement account (IRA), the income grows on a tax-deferred basis and you will be taxed only when you make a withdrawal.

Rate of return

Mutual funds generally offer higher returns on your investment compared to annuities. One of the reasons behind the higher-than-average rate of return is that the expenses associated with these funds are typically very low.

The expenses associated with annuities, on the other hand, are high — more than 2% in many cases — due to the annual fees, administrative charges, mortality and expense charges, and various other fees charged by the insurance company.

All these charges are typically deducted from your annual profits, as a result of which the overall returns on your investment is lower compared to mutual funds.

Liquidity

Mutual funds are a liquid asset, since there is no lock-in period and you can sell your shares any time you want. Annuities, on the other hand, have a lock-in period, which can be as long as 10 years. If you withdraw the money during the lock-in period, you have to pay a surrender charge, which can be as high as 8% in the first couple of years.

Choosing between annuities and mutual funds

As you can see, annuities and mutual funds have their own advantages and disadvantages, as is the case with all other investments. If you are in need of a reliable source of income, annuities might be the right choice for you.

If you, on the other hand, need higher returns on your investment, mutual funds might be the better choice. You can make a decision based on your age, health condition, financial situation, and your day-to-day financial needs during your retirement years.

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