Annuities vs. CDs: How Do They Compare?
When there is economic uncertainty, most people crave safety, especially if they plan to retire in a few years. Although they are well aware of the erosive effects of inflation on their wealth, many pre-retirees are afraid of losing money they don’t have time to replace. That’s why those near retirement often seek to transfer their more vulnerable assets to safer vehicles, such as annuity products or bank Certificates of Deposit (CDs).
But how do these two products compare? Is there a clear answer to the choice between an annuity vs. CD? Keep reading to find out.
What Is an Annuity?
An annuity is a financial product offered by insurance companies to help consumers save for retirement. Most annuities (with the exception of variable annuities) offer either fixed-interest growth or guaranteed minimum interest rates, and protection of your initial contributions against loss.
Annuities can start paying out immediately, or be deferred for long-term growth before annuitization, and all interest earned by annuities is tax-deferred. You can also add riders to most annuity products to cover health-related expenses or provide death benefits to your loved ones after your passing.
Note: All guarantees are subject to the claims-paying ability of the insurer.
Note: Riders may be subject to eligibility and underwriting requirements, additional premium requirements and/or minimum or maximum coverage amounts. Availability and rider provisions may vary by state.
What Is a Certificate of Deposit (CD)?
A CD is a financial savings account offered by institutions like banks and credit unions. Typically, a consumer pays a lump sum to purchase a CD. That money is then held by the bank for a set period of time, during which it accrues interest at a fixed rate. If the consumer withdraws funds from the CD early, they may forfeit all interest gained and have to pay a penalty fee.
CD terms can range from a few months to several years. At the end of the period, the CD reaches “maturity.” At this point, the CD owner can either withdraw their funds, restart the CD, or transfer their money to another financial product.
Shared Traits of Annuities and CDs
Both CDs and annuities offer lower-risk opportunities to grow your savings, among other similarities.
Account Security
Annuities and CDs are similar in that they are lower-risk products that typically offer guaranteed growth based on interest rates. Both are issued by large financial institutions, with CDs issued by banks and annuities offered by insurance companies.
No Exposure to Market Risk
Neither annuities, excluding variable annuities, nor CDs come with the same risks as mutual funds, ETFs, and securities. CD interest rates are based on the Federal Reserve rate, but once you purchase a CD, the rate is locked in for the entire CD term. Annuity rates may vary based on the type of annuity you choose, but both fixed and indexed annuities keep your money entirely out of the stock market.
Short- and Long-term Options
Annuities and CDs come with a variety of term choices. CD contracts can range from three months to upwards of 10 years. Annuities can begin paying out almost immediately, or accumulate interest for years before annuitization.
How Annuities and CDs Differ
While CDs and annuities offer safer options for growth than market investments, there are several key differences to consider when making your choice.
Taxes
Interest accrued by a CD is considered income, even if the account hasn’t fully matured yet. For example, a five-year CD will still send you a 1099 every year. You’re responsible for paying annual taxes on interest earned by your CD without being able to withdraw funds until your investment term is over.
Annuity interest is only exposed to tax liability when the funds are accessed, either by the annuitant or later to a named beneficiary. So with annuities, the deferred tax on your interest remains in the account earning you more and more money, instead of being paid out to state and federal tax agencies on a yearly basis.
Both CD and annuity interest are subject to ordinary income tax, whereas earnings from investing in securities may be taxed more highly as capital gains.
Note: Any reference to the taxation of annuities in this material is based on Annuitiy.com’s understanding of current tax laws. We do not provide tax or legal advice. Please consult a qualified tax professional regarding your personal situation.
Account Protection
In many states, an annuity has some level of exemption from creditor liens and judgment. The amount that can be protected varies based on your state of residence. A CD can be garnished or seized. In most situations, a bank CD is an exposed asset to creditors.
However, CDs do have FDIC protection to guard against bank or banking industry failure. Typically CDs are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), the same as other bank accounts. While insurers are expected to have sufficient funds to cover claims, there is no federal insurance against loss of principal for annuities.
Interest Rates
As consumers, we think of interest as interest. In fact, there are two different and distinct factors that separate banks and annuities when calculating interest on savings vehicles.
Bank CD interest rates are calculated on the discount cost of money, which is set by the Federal Reserve Board. Most annuity rates are based on the 10-year US Treasury which is a longer vision into interest rates. Typically, 10-year US Treasury rates are higher and steadier than Fed Rates, which can make it easier to purchase an annuity with a great rate whenever you’re ready.
Annuity interest outperforms CD rates in many cases due to the extended amount of time they accumulate earnings and their tax-deferred advantages. Indexed and variable annuities may offer more exposure to higher interest rates, though variable annuities are also subject to market downturns.
Access to Funds
For the most part, CDs will not let you liquidate without penalties such as loss of interest and/or withdrawal fees.
In some cases, annuity owners can withdraw up to 10% per year without incurring penalties. Annuities often also have contractual guarantees that allow for access under specific conditions, such as a prolonged nursing home stay. These features are often purchased separately as riders.
That said, annuity withdrawals that occur before the age of 59 ½ may be subject to early withdrawal penalties from the IRS, even if the annuity has matured. Funds from mature CDs can be received at any time without IRS penalties.
Payout Options
Annuities can be structured to pay out in a lump sum or periodic payments for the term of the contract, be it five years or twenty, thereby spreading out your tax burden and providing enhanced income security. When paired with a lifetime income rider, annuities can be set up to continue paying income for the rest of the annuitant’s life, even if the principal and accrued interest run out.
Unless the funds in a CD are reinvested for another term or moved to another financial product, your principal and earned interest are returned in full as a lump sum upon maturity. There is no annuitization option within a CD.
Death Benefits
Upon your death, your CD may be subject to probate expenses, and payments to your loved ones may be delayed. Annuities are contracts, and you are allowed to name a beneficiary. Named beneficiaries can receive proceeds without probate expense or time delay.
Rider Benefits
In addition to lifetime income riders and death benefits, annuity contracts offer additional riders and flexible contract options to secure your financial future. For example, cost-of-living-adjustment (COLA) riders can build periodic increases into income payments to help you keep up with inflation during retirement. Long-term care riders can increase payments during long-term care stays to help cover costs.
CDs do not offer riders or add-ons in this way.
How to Choose Between Annuities vs. CDs
After exploring their goals and risk tolerance, many pre-retirees choose to balance their retirement accounts with lower-risk products, such as annuities or bank CDs. While CDs are traditionally a safer choice, annuity products offer some additional advantages. In deciding whether to place money in an annuity or a CD, you should ask yourself:
- Am I saving this money for retirement, or do I need access to earnings during my working years?
- Do I want the protection of an FDIC-insured bank product?
- Do I want a lump sum or a stream of guaranteed, predictable income with flexible payout options?
- Can I afford a lump sum payment, or do I need to make premium payments over time?
- What are my long-term and short-term money goals?
- Is it necessary for me to have a product I can customize to meet my needs?
- Do I need to be able to access my funds without penalty?
- Would I like to use this product to plan for long-term care needs?
- Am I looking to create a legacy for my loved ones with death benefits?
Both annuities and bank CDs offer wealth protection. However, for those with specific retirement income goals, annuities may fit better with their long-term financial objectives. Often a combination of short (bank CD) and long positions (annuity) can provide a higher yield overall.
While there is no “correct” answer for everyone, both choices have benefits. Your decision should be based on your specific situation and goals. When considering these choices, it’s wise to meet with a qualified insurance agent who has particular knowledge about annuity products and the retirement phase of life.
