Annuity Vs. Tax-Free Bond Fund

Choosing between annuities and tax-free bond funds can be confusing.
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Annuities and tax-free bond funds are both ways you can invest and save on taxes. However, the two investments are pretty dissimilar beyond that. From the structure of the investments to the income they generate to the way they avoid taxes, annuities and tax-free bond funds are clearly different. Both may serve important roles in your portfolio, depending on what you want out of your investments and how much flexibility you need.

Structure

Tax-free bond funds invest in municipal securities, which are issued by state and local governments. These issues pay interest free from federal tax. In some cases, interest is also tax-free in the state of issue.

Annuities are products issued by insurance companies, and they come in three flavors: fixed, indexed and variable. Fixed annuities promise regular income payments for a specified time, usually the lifespan of the owner. Indexed annuities attempt to replicate the performance of an outside index, such as the S&P 500 stock market index. Variable annuities allow investors to put money in sub-accounts that are similar to mutual funds, offering a variety of growth or income investments.

Payouts

The main reason to invest in a tax-free bond fund is to earn tax-exempt interest. Tax-free bond funds typically pay interest to investors monthly. You can either take the income directly or have it reinvested into additional shares of the fund.

Both fixed and variable annuities have two phases: the accumulation phase and the annuitization phase. During the accumulation phase, your annuity is earning money. In the case of a fixed annuity, earnings are based on the issuer-stipulated interest rate, while in a variable annuity earnings are based on the performance of your investment sub-accounts. Once you switch to the annuitization phase, you can begin taking withdrawals. You can take your money out all at once, or you can receive a set amount monthly over a specified period -- usually until you die.

Taxation

Income paid out by a tax-free fund is usually exempt from federal taxes, as the name would imply. Since income paid from a municipal bond is usually tax-exempt in the state of issue, most funds provide a year-end summary of the income earned. Funds may occasionally pay out capital gains distributions, representing gains earned from buying and selling, which are taxable.

Annuity taxation can be a bit more complicated. Any earnings paid out of an annuity are taxable at ordinary income tax rates. However, annuity payouts also consist of a return of the money you originally put in. As a result, only a portion of your annuity payments will be taxable. Your annuity company will usually calculate your exclusion ratio for you, which tells what percentage of each payment is taxable.

Fees and Expenses

To buy a tax-free bond fund, you may have to pay a sales load, or commission. You might also pay a fee to sell a fund, although this is less common. Every year, the fund will deduct money to cover the costs of running the fund.

With an annuity, you may face both a management fee and a mortality and expense fee, which is used to cover the insurance portion of your investment. You'll also generally be assessed a surrender charge -- which can often top out at 7 percent or more -- if you sell your annuity within the first few years after you purchase it. A tax that might make annuities unsuitable for younger investors is the 10 percent "early withdrawal," which the IRS tacks on to most annuity withdrawals before age 59 1/2.

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