Are you torn between an annuity and a certificate of deposit (CD)? Both options are a safe way to grow your money and earn a guaranteed return. However, there are key differences between the two to be aware of in order to decide which is best. Here’s a closer look at the ins and outs of annuities and CDs, the pros and cons of each, how they stack up against each other, and factors to consider to make an informed decision.
What Is an Annuity?
An annuity is a financial product that insurance companies offer to aid in retirement planning. It is designed to provide you with a steady income stream over time. You purchase an annuity by making a series of payments or a one-time lump sum investment. This offers a predictable income that can help cover living expenses in retirement.
There are several types of annuities to choose from, which will be discussed shortly. Regarding rates, they vary based on market conditions. That said, they are typically much higher than those that come with traditional savings accounts.
How Annuities Work
Once you purchase an annuity, the insurance company then makes regular payments to you. You can choose to receive payments right away or at a later date. Payouts can also be structured for a set period or the duration of your life to meet your needs.
What Is a Certificate of Deposit (CD)?
A CD is a savings product offered by banks and credit unions. You deposit a fixed sum for a preset period, ranging from a few months to several years. In return, the financial institution pays you interest.
Like annuities, there are many variations of CDs – some more flexible than others. They, too, feature impressive annual percentage yields (APYs) that are higher than what you’d get with a savings account.
CDs are also insured by the Federal Deposit Insurance Corporation (FDIC), which backs deposits of up to $250,000 in case of bank failure. This same level of protection applies to CDs held at credit unions through the National Credit Union Administration (NCUA).
How Certificate of Deposit (CD) Work
When you lock your money in a CD, you essentially agree not to touch it until the term ends. At the time, you can withdraw the funds, roll them into a new CD with the same or different terms, or create a CD ladder by opening several additional CDs. Otherwise, you’ll incur an early withdrawal penalty that eats into your interest earnings and possibly your principal.
Types of Annuities
Here’s an overview of the types of annuities available to you:
- Immediate Annuities: Immediate annuities allow you to start receiving payments almost immediately after an initial lump-sum investment. Payments typically begin within a year and can continue for a specific period or the rest of your life. Remember that, once started, the terms usually can’t be changed.
- Deferred Annuities: Deferred annuities start payments at a future date, allowing your investment to grow tax-deferred until distributions begin. There are fixed and variable rate options, and the primary draw is the increased growth potential during the deferral period. However, premature distributions could result in penalties.
- Fixed Annuities: Fixed annuities provide a guaranteed interest rate for a specified period. These are attractive if you prefer a low-risk, steady income option similar to a certificate of deposit, where you can expect a fixed rate of return. And you can shield your funds against market fluctuations.
- Variable Annuities: Variable annuities allow you to invest in a selection of sub-accounts, including stocks and bonds. These offer the potential for higher returns based on market performance and let you tailor investments to fit your risk profile. That said, you face greater risks due to market volatility and higher fees.
Benefits and Drawbacks of Annuities
Pros
- Guaranteed returns
- Predictable interest rate over time (fixed annuities)
- Tax-deferred until paid out
Cons
- Not federally insured
- Steeper fees compared to other investment options
- Penalties for early withdrawals
Types of CDs
You can choose from any of these CDs:
- Traditional CDs: As previously stated, traditional CDs require you to deposit a fixed amount of money for a set term, which can range from a few months to several years. You get a fixed interest rate and predictable interest earnings. However, if you withdraw funds before the maturity date, you will likely incur an early withdrawal penalty.
- Jumbo CDs: Jumbo CDs are similar to traditional CDs, but they require a significantly larger initial deposit, often $100,000 or more. Because of the higher deposit requirement, you usually receive a higher interest rate than regular CDs.
- Callable CDs: Callable CDs offer a twist on the standard CD terms. While they typically offer a higher interest rate, the issuing bank retains the right to redeem or “call” the CD before its maturity date, usually after an initial lock-in period. If interest rates drop, the bank may choose to call the CD, which can negatively impact your interest earnings.
- No-Penalty CDs: No-Penalty CDs provide greater flexibility than traditional CDs by allowing you to withdraw your money without penalties before the maturity date. They offer a lower interest rate compared to traditional CDs. Still, the absence of early withdrawal penalties can make them a suitable choice if liquidity and access to your funds are a top priority.
Benefits and Drawbacks of CDs
Pros
- FDIC or NCUA-insured for peace of mind
- Higher APYs than savings accounts
- Fixed interest rate gives you predictable earnings
Cons
- Early withdrawal penalties
- Potential forfeiture of interest earnings if rates rise during the CD term
- Limited liquidity
Comparing Annuities and CDs
Risk and Return
- Annuities: Annuities, especially variable ones, involve more market risk, with returns tied to the performance of chosen investment options. Still, fixed annuities provide more predictable returns that may exceed those of CDs.
- CDs: CDs are typically a safer investment as they are insured by the federal government up to a specific limit, offering predictable returns. That said, they usually offer lower rates compared to annuities.
Liquidity and Access to Funds
- Annuities: Annuities may offer more ways to access your money. Some annuities allow early withdrawals, but you may be subject to surrender charges.
- CDs: If you need to access your money before the CD matures, you might face early withdrawal penalties. This can limit your liquidity and access to funds.
Tax Treatment
- Annuities: Annuities offer tax deferral on earnings, which means you pay taxes upon withdrawal.
- CDs: The interest earned on CDs is typically taxed as ordinary income in the year it is earned.
Cost and Fees
- Annuities: Annuities typically involve more fees, including administrative and management charges.
- CDs: CDs generally involve fewer costs – the primary one is the early withdrawal penalty.
Factors to Consider When Choosing Between Annuities and CDs
Before deciding whether to go with an annuity or CD, consider these factors.
Investment Time Horizon
CDs are more of a short-term option, while annuities are designed to be more long-term investments.
Financial Goals
CDs are a way to preserve capital and meet short-term financial goals, while annuities are ideal for long-term financial goals.
Risk Tolerance
CDs are considered low-risk investments since they are federally blacked, while annuities involve more risk if linked to market performance.
Ideal Situations for Choosing Annuities
- You seek long-term financial stability and a reliable income stream in retirement.
- You have maximized other tax-advantaged retirement accounts, including IRAs and 401(k)s.
- You prefer greater returns than CDs offer and are willing to assume some level of risk.
- You’re concerned about outliving your savings.
Ideal Situations for Choosing CDs
- You want a safe place to park your money and earn a guaranteed return.
- You need to meet a short or medium-term savings goal.
- You can commit to locking away your cash for an extended period.
- You need access to your funds in the near future without incurring significant penalties.
