Fixed Annuities vs. Certificate of Deposits (CDs)

Fixed annuities and certificates of deposits (CDs) are frequently used by individuals to supplement their retirement income, and though there are some similarities between them, they are different.  Those looking to invest in either one should clearly understand those differences, in order to make the appropriate choice.

Fixed Annuities

A fixed annuity is a financial contract between an individual (the contract owner) and an insurance company.  This product provides the owner and or an annuitant (the individual upon whose life the contract is written) with a series of periodic income payments, usually at retirement.  Fixed annuities provide a specific interest rate that is often guaranteed for 1 to 7 years, or longer.

Annuities have two phases, the accumulation and income phase. 

  • Accumulation Phase is the period during which the owner contributes funds to the annuity and watches the funds grow on a tax-deferred basis.  During this phase owners may make changes to the contract and take withdrawals according to contract  provisions.

  • Income Phase is the period during which the annuitant receives income from the annuity contract according to an elected settlement/payout option.  No changes to the contract may be made once the settlement option is selected.

Taxes are applied to the portion of withdrawals and income payments in excess of the initial deposited amount.  These “gains” or earned interest amounts are taxable as ordinary income and reported to the owner on an IRS 1099 Form at the end of each year for documentation when filing their taxes.  Withdrawals made prior to age 59 ½ (certain exceptions apply) are subject to a 10% early withdrawal penalty by the Internal Revenue Service. 

Certificate of Deposit (CD)

With a certificate of deposit, an individual deposits a sum of money in either a bank, savings and loan association, or a credit union for a fixed time period, often 1 to 5 years.  Shorter and longer durations are also available.  The financial institution provides a specific interest rate, typically increasing with the length of term.  When a CD matures, the owner receives the original sum plus accumulated interest.  The accumulated interest is taxable as ordinary income and reported to the CD owners on an IRS 1099 Form at the end of each year for documentation when filing their taxes.

Flexibility

Annuities offer more flexibility than CDs – they can provide income to an annuitant right away (immediate annuity), or at a future date (deferred annuity).  Annuitants can receive income for a specified period of time such as, 10, 15 or 20 years, or for as long as they live.

Safety

Both vehicles are among the safest investments - CDs generally are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC) while annuities are backed by the financial strength of the issuing insurance company.

Tax Deferred Growth vs. Taxable Growth

Although both CDs and annuities offer competitive interest rates, funds in annuities grow more quickly because of their tax deferred feature.  The following example illustrates the growth of a tax- deferred annuity vs. a fully taxable CD.  The difference is substantial.

 

Assumptions:

  • Initial investment: $50,000
  • A 4% interest rate return for the annuity and CD
  • A 28% individual tax bracket

 

The Accumulated Value in 30 Years:

  • Annuity:   $162,170
  • CD:            $117,192

To compare the results accurately, we must account for the taxes that are paid on the gain portion of the annuity. 

($162,170 - $50,000) X 28% = $31,408

$162,170  - $31,408 = $130,762 net amount to the annuity owner

 

The Net (after tax) Accumulated Value in 30 Years:

  • Annuity:          $130,762
  • CD:                   $117,192
  • Difference:      $ 13,570 

Liquidity

Both vehicles permit access to funds during their terms, but annuity is the only one providing for a 10% free withdrawal.  In addition, annuities often offer nursing home and terminal illness riders, allowing for a portion of funds to be paid to the owner to cover part of their nursing home and/or other costs.

Inclusion in Probate

While money in a CD is usually included in the owner’s estate and submitted to probate, annuity funds by-pass probate and paid directly to named beneficiaries without delay at owner’s death. 

Penalties

Penalties apply to both annuities and CDs when the money is withdrawn, but they are structured differently.

Annuities are considered long-term savings vehicles; therefore, Insurance companies impose surrender charges to dissuade owners from withdrawing too much money from their annuity during a specified period of time, often 5 to 7 years.  However, free withdrawals of up to 10% annually are usually allowed on fixed annuities.

A CD restricts access to the funds until it is matured.  Though it is possible to withdraw money prior to the maturity date, it is not advised to do so due to an early withdrawal penalty, which typically, is the amount of interest that the CD would have earned during its term.  CDs do not permit any free withdrawals.  When a CD matures, the funds can be taken out, or the CD may be renewed for another term.

Key Factor in Choosing Annuity or CD

The length of time you need to save for a specific goal should be a key factor in deciding between an annuity and a CD.  For a short term goal, such as a down payment on a house or a car, a CD may be a more appropriate choice.  A fixed annuity, on the other hand, is generally designed to provide for a long-term goal, such as supplementing your retirement income.