Mutual funds consist of a collection of different investments, sold in shares and purchased by large numbers of individuals. It's a pooling of money to achieve diversification. Each person owns a share of the fund, not a particular investment. A variable annuity is a retirement account that receives preferential tax treatment. Annuities seem to contain mutual funds, but these are really sub-accounts, a minor technical difference. There are other more meaningful differences, though.
When you sell mutual funds or receive a dividend or capital gain, the IRS taxes you in the year you receive it. You can offset any gain with a loss if you have it the same year. If a similar sub-account in an annuity receives dividends, capital gain or you sell shares, you pay no taxes that year. Because gains and losses accumulate along the way, you ultimately pay taxes on any growth in the contract when you remove the money.
When you hold mutual funds longer than a year and then sell them, you incur a long-term capital gain. The tax on long-term gains varied in 2010 from 0 percent to 15 percent. While those percentages may revert to 10 percent and 20 percent if Congress doesn't renew the Bush tax cuts, they are still lower than the percentage for ordinary income. When you take funds out of an annuity, all growth is taxed as ordinary income, no matter how long you held the annuity.
Last In First Out Rule
If you sell shares of a mutual fund, you get to select the shares to calculate the basis, the amount you paid for the shares. You subtract the basis from the sale price to determine how much is taxable. You pay no taxes on the cost of the shares. The IRS uses the LIFO rule on annuities. That means, last in, first out. Because growth is normally the last in the contract, the IRS says it's always the first out. Until you remove enough money so that only principal remains in the contract, everything you take out is taxable.
If you're under 59.5 years old and you take money out of an annuity, you pay a 10 percent penalty and taxes on the growth. Because it's a retirement vehicle similar to an IRA and receives tax deferrals, it has similar rules.
Annuities contain funds from many different families. If you sell a fund from one fund family and invest the money in another inside the annuity, you don't pay a load or new sales charge. The same is not true for mutual funds. Selling one fund and purchasing a new fund from a different fund family triggers a new charge.
You can add guarantees to your variable annuity that you can't add to mutual funds. While these cost a certain fee every year, normally a fraction of a percent of your balance, they can provide a specific return, a guaranteed death benefit, safety of principal or a guaranteed income. Only insurance companies, which produce annuities, can offer this type of "insurance."
Aside from the guarantees, insurance companies originally created annuities to provide a lifelong income at retirement when you annuitize them. This is the process where you turn your lump of cash into payments. Your lump sum disappears when it becomes payments. While you can take payments from mutual funds, there is no option to guarantee a payment for a specified period or that you'll never run out of money.