Mutual funds and tax-deferred variable annuities are two of the most well-known financial products to the general public. Since a tax-deferred variable annuity is basically a "mutual fund placed in an annuity wrapper", it is not surprising that potential investors often compare the features, merits and disadvantages of these two types of financial products.

A mutual fund is an open-end investment company in that it continually issues new shares. Mutual fund investors can purchase shares directly from the company or through its underwriters at the public offering price. A tax-deferred variable annuity, usually purchased for the purpose of retirement, is basically an insurance contract between the individual and the insurance company. It is a hybrid product in that it contains characteristics of both insurance and a retirement account. The owner of the tax-deferred variable annuity pays premiums to buy accumulation units (as opposed to "shares"). The accumulation units are held in a separate account, referred to as the "variable account." The variable account contains the subaccounts. The subaccounts function like mutual funds. Each subaccount is invested in a portfolio with specific investment objectives (e.g., asset allocation, balanced, bond, index or stock). As with a mutual fund, the investment value of the fund subaccounts in the variable annuity will fluctuate in accordance to the market prices of the underlying securities. Also, as with mutual fund shares, the value of the annuity's accumulation unit is calculated each business day. Despite a few elements of superficial commonality, there are critical differences between mutual funds and tax-deferred variable annuities:

1. A mutual fund is an investment product, whereas a variable annuity is, foremost, an insurance product.

2. Variable annuities tend to have higher fees and expenses than mutual funds including costly surrender charges. They also have other types of fees not associated with mutual funds such as the mortality and expense risk charge. Additional fees will be imposed for special features such as a "stepped-up death benefit." Depending on the state and local government, premium taxes may also be assessed on variable annuities. The "average" expense ratio for variable annuities is also somewhat higher than that of mutual funds due to the insurance-related expenses.

3. Unlike mutual funds, tax-deferred variable annuities are less "liquid" in that they impose penalties for early distributions. A 10% federal penalty can be assessed for early withdrawals before the age of 59 1/2 in addition to other applicable taxes and fees.

4. The performance of mutual funds is generally far easier to track than the performance of variable annuities.

5. In contrast to mutual funds, variable annuities contain some type of death benefit guarantee (before annuitization). The death benefit the beneficiary receives is generally the greater of (a) the current value of the annuity contract or (b) at least a guaranteed minimum such as the total amount invested in the variable annuity minus any prior withdrawals.

6. If the investor is likely to be in a lower tax bracket, the withdrawals (the earnings) from the tax-deferred variable annuity will be taxed as ordinary income. If the tax bracket is the presumed to be the same, the long-term capital gains tax is more advantageous for mutual funds.

7. A mutual fund transfer may result in capital gain taxes. A tax-free transfer among subaccounts is permitted in a tax-deferred variable annuity through a 1035.

8. Tax-deferred variable annuities do not provide the step-up cost basis advantage of mutual funds when the annuity owner dies.

We have only briefly discussed some of the key differences between mutual funds and tax-deferred variable annuities. Both are complex and risky investment instruments. The primary interest in tax-deferred variable annuities is obviously due to the tax-deferral of earnings and appreciation during the accumulation stage. However, that should never be the sole criterion in the selection process. From a financial planning perspective, the comparative advantages and disadvantages of a mutual fund and a tax-deferred variable annuity should carefully and thoroughly evaluate the following: fees and expenses, holding period, liquidity, tax treatment and historical performance. All of these concerns must be framed in the context of an individual's investment needs and objectives, stage of life, risk tolerance, time horizon, financial situation and tax bracket.


For informational purposes and not intended as advice. Every attempt is made at accuracy, however, the writer does not claim that content is free of factual errors.