CD Accounts vs Annuity
Investors considering annuities and/or certificates of deposit (CDs) are typically looking for safety, a certain level of guarantees and a fixed rate of interest. So which is the better investment?
An annuity is a contract with an insurance company. You make a single purchase payment or a series of payments to the company. The annuity can provide a lifetime stream of income or payments over a contractually defined term. If you purchase a fixed annuity, the interest earned on the annuity and the amount of income payments are fixed, as opposed to variable annuities in which interest earned and income payments will vary based on investment performance.
Fixed annuities are often compared to CDs in that they pay a guaranteed rate of interest. Annuities typically pay a higher rate of interest than CDs.
CDs are savings instruments issued by banks and savings and loans. When investing in a CD, you, in effect, lend the bank or savings and loan a set amount of money that it then invests in securities or loans. You are ensured the return of your original principal plus a set rate of interest over the life of the certificate of deposit. CDs offer a variety of maturities and interest payment options.
Here is a comparison of the income options, liquidity, fees and taxation of annuities and CDs.
Short-term CDs typically pay interest at maturity. CDs with terms of two to five years or more will often pay interest as income, either monthly, quarterly or semiannually, then return the owner’s original principal at the end of the term. If you invest $100,000 in a 5-year CD paying a 2.35 percent yield, it would pay you around $200 a month for five years. At the end of the term, you would get the original $100,000 back. The longer the term, the higher the rate.
Annuities provide greater flexibility on how they pay out income. Unlike CDs, some annuities can pay out a lifetime income stream, regardless of how much interest it earns. A 60-year-old investing in a $100,000 fixed-rate immediate annuity could receive $500 in monthly income for the rest of his or her life. You can purchase an immediate annuity if you need income right away. Or you can buy a deferred annuity to take income after you’ve owned it for several years.
With an immediate annuity, you give an insurance company a one-time premium payment. The company subtracts fees from that premium, then calculates your lifetime income payment based on your age and gender. The older you are when you buy the annuity, the higher your income payments.
A deferred annuity allows you to defer your income stream for several years. During the accumulation phase, the annuity’s account value grows tax-deferred based on the fixed rate of interest set by the insurer. When it comes time to take income, you can choose a lump sum of your account value or a stream of periodic payments. With the stream of payments, you can choose how long you want to receive income, be it for a set number of years or for life.
Some annuities also offer optional income riders. These riders provide a lifetime income stream that you can turn on in the future. They also gives you the flexibility of stopping income and restarting it again. The value of an income rider grows at a contractually guaranteed rate.
Both vehicles have limitations on how easily it is to access funds and assess penalties if owners withdraw funds before maturity. CDs typically win in this department because they can be purchased with maturities of as low as one month. Plus the early withdraw penalty on CDs is typically lower than on annuities because it’s based on a certain amount of interest the CD pays, typically three to six months worth.
On the the other hand, annuity surrender charges are based on a percentage of its account value at the time of early withdrawal. However, many annuities offer free withdrawals during the surrender period, typically equal to 10 percent of the contract’s account value.
Fixed annuities charge annual fees that may total 2 percent to 3 percent or more of the account value. These include a mortality and risk expense charge, and an administrative fee. There will also be fees for any optional benefits (see below). Bank CDs typically have no fees assessed.
Money deposited in an annuity grows tax-deferred until you take distributions. Because of this, you must wait until age 59 1/2 to withdraw funds from the annuity. Doing so prior to age 59 1/2 will result in a tax penalty. When you receive income from the annuity, you will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it.
The interest earned on CDs is fully taxable.
One of the advantages of CDs is that, because they are bank products, they are insured by the Federal Deposit Insurance Corp. (FDIC). That means if the issuing bank fails, the FDIC will insure the CD up to an amount of $250,000.
Annuities are backed by the issuing insurance company. State guaranty associations do insure policy holders against the failure of insurance companies, but not to the extent of the FDIC.
One additional advantage annuities have over CDs is that they pay the proceeds penalty-free to a designated beneficiary upon the death of the owner. They also avoid the expense and delay of probate, which CDs do not.