If you buy an immediate annuity, you purchase the contract with a lump sum payment and the annuity issuer provides you with an income stream. You could use the income payments to buy mutual fund shares, but you cannot take back the lump sum and invest it in shares. However, if you buy a deferred annuity you can move your money to mutual funds; you can even do this while keeping your money inside an annuity contract.
Deferred annuity contracts provide a tax shelter for your money, but this means that you have to pay taxes when you make withdrawals. You have to pay taxes on any money that you access that has not been previously taxed. You must add this money to your taxable income for the year, which could push you into a higher tax bracket. Federal tax brackets rise as high as 35 percent; you may also have to pay state income taxes.
Deferred annuity contracts begin with an accumulation phase. You have to pay surrender fees if you withdraw your money during this period. The accumulation phase could last for as long as 10 years. Having paid the taxes and fees, you can invest the remaining money into mutual funds.
Individual Retirement Arrangements
You can buy a deferred annuity contract with your individual retirement arrangement (IRA) money and when you do so, you hold the contract inside an IRA account alongside your other retirement investments. IRAs, like annuities, provide a tax shelter for your money. This means that you can liquidate an IRA annuity without having to pay taxes as long as you keep the proceeds in the IRA. You can then buy mutual funds with the IRA money and avoid having to pay taxes until you actually withdraw money from the IRA.
If you buy a fixed deferred annuity, the insurance company holds your money inside an account that pays a fixed rate of return. If you buy an equity indexed annuity, your funds are held in an account that tracks a stock market index like the Dow Jones Industrial Average. However, variable annuity contracts contain mutual funds and fixed accounts. If you have an existing variable annuity you can transfer money from the fixed subaccount to a mutual fund within the contract. If you own a fixed or equity indexed annuity you can move your money to a variable annuity during a process called a 1035 exchange. Your premium and your account earnings remain sheltered from tax before and after the exchange, although you may pay fees to the annuity providers.
If you buy a mutual fund within an annuity, you have to pay the same sales charges that you would pay if you bought fund shares with non-annuity money. However, you also have to pay annuity contract fees that pay for the insurance guarantees that comes as part of an annuity contract. Do not invest your money in a new annuity contract if you plan to withdraw the funds before the contract ends because you stand to lose your earnings to contract and penalty fees. On the other hand, if you have no immediate need of the money, then a 1035 exchange provides you with the opportunity to shield your earnings from taxes. Therefore, consider your tax situation and your long-term plans before you move money from an annuity to a mutual fund.
- Schwab; Does Your Variable Annuity Cost Too Much?; Rande Spiegelman; February 2008
- Securities and Exchange Commission; Variable Annuities -- What You Should Know; April 2011
- Edward Jones: Annuity Taxation
- IRS. "IRA FAQs - Contributions." Accessed Oct. 30, 2020.
- Internal Revenue Service. "When Can a Retirement Plan Distribute Benefits?" Accessed Oct. 30, 2020.
- Annuity.org. "Deferred Annuities." Accessed Oct. 30, 2020.