Key Takeaways
- Annuities are financial contracts usually issued by insurance companies, and certificates of deposit are savings accounts issued by banks and credit unions.
- Annuities are long-term vehicles popular for optimizing retirement plans, while investors typically use CDs to generate near-term income on excess cash.
- Annuities are more complex than CDs. They also offer more flexibility and the potential for higher returns. Annuities can satisfy various investment objectives, while certificates of deposit focus on providing yield.
Annuities and certificates of deposit (CDs) are both safe investments that appeal to people who favor guaranteed returns and principal protection over aggressive growth.
That said, they are not interchangeable. Annuities are more complex than CDs. They also offer more flexibility and the potential for higher returns.
Annuities and Certificates of Deposit Explained
Most often, an annuity is a financial contract between an individual (the annuitant) and an insurance company (the issuer). From the annuitant’s perspective, it entails converting a lump sum into a series of immediate or deferred income distributions, which they can customize in terms of size, timing, variability and duration.
A certificate of deposit (CD) is a type of savings account offered by banks and credit unions. It provides a guaranteed rate of interest in exchange for a commitment to leave your money on deposit for a specified term. However, early withdrawal will cause a loss-of-interest penalty, which usually equates to a certain number of months of interest.
Annuity vs CD Features: A Comparison
Before purchasing an annuity or a CD, make sure you understand the way each instrument works. Comparing their similarities and differences is a sensible way to educate yourself.
Comparing Annuities and CDs
| Annuities | Certificates of Deposit | |
|---|---|---|
| Primary Purpose | Retirement income | Incremental interest income |
| Tax Treatment | Tax-deferred growth of principal | Interest income taxed annually |
| Safety | Backed by issuing insurer and state guaranty associations | Backed by the FDIC or NCUA |
| Customizable Features | Yes | No |
Similarities Between Annuities and CDs
There are various types of annuities, including fixed, indexed and variable annuities. Multi-year guaranteed annuities (MYGAs), a type of fixed annuity, are most similar to CDs.
Like a CD, a MYGA requires an investor to lock up his or her money for a specified period, while interest income accumulates in a risk-free fashion. At the end of the accumulation period, the investor receives the principal and accrued interest.
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Differences Between Annuities and CDs
CDs and Annuities are both secure investments. However, CDs are more flexible with shorter terms and lower withdrawal penalties. Annuities generally offer higher interest rates and provide periodic payments, while CDs pay a lump sum at maturity.
Another significant difference pertains to the degree to which these instruments can be customized. Annuities are highly customizable, offering investors an array of optional add-on features commonly referred to as annuity riders. CDs offer no such optionality.
Below are a handful of other notable differences between annuities and CDs.
Safety
In terms of safety, CDs are near the top of the list of all investable assets. They exhibit zero volatility and, if structured properly, are insured up to $250,000 for individual accounts and $500,000 for joint accounts. The Federal Deposit Insurance Corporation (FDIC) insures CDs issued by banks, and the National Credit Union Administration (NCUA) insures CDs issued by credit unions.
Because the federal government does not insure annuities, they are not as safe as CDs. However, as long as a financially sound insurance company issues them, the backing of various state guaranty associations still makes annuities much safer than bonds, stocks and alternative assets in general.
Interest Rates
The interest rates offered on CDs are generally lower than the interest rates available from annuities. Over long periods of time, even a 1% or 2% differential can make a huge difference in terms of accumulating wealth.
Tax Treatment
The IRS allows nonqualified annuities — those paid for with after-tax funds — to grow on a tax-deferred basis. They do not grant CDs the same advantage.
The IRS requires annual taxation of the earnings on CDs (except those held in tax-advantaged retirement accounts). This goes for coupon-paying and zero-coupon CDs. Unfortunately for zero-coupon CD holders, this results in an adverse mismatch of cash flows.
Liquidity and Penalties
Given their longer terms, annuities are generally less liquid than CDs. Moreover, the contractual penalties for withdrawing money prematurely from annuities are usually much greater than those for CDs.
Withdrawing funds from an annuity during its accumulation phase typically results in a penalty of 10% of the value of your investment. Additionally, if the withdrawal is made by an annuitant under the age of 59½, the IRS will impose an additional 10% penalty.
Conversely, if you redeem a CD prior to maturity, the penalty usually amounts to the loss of a few months of interest, but no forfeiture of the principal.
Beneficiaries
The money invested in both annuities and CDs can be passed on to heirs. However, the process is more straightforward with annuities.
In the event of an annuity owner’s death, named beneficiaries are not required to go through probate court to claim their benefits. Conversely, if a CD does not have a payable-on-death beneficiary and is not part of a living trust, irrevocable trust, or joint account, a deceased’s heirs must go through probate to obtain the inheritance.
Lock In Fixed Annuity Rates as High as 6.4%
CDs and annuities both provide safe, secure options for conservative investors. CDs are more beneficial for short-term savings or emergency funds that might be needed within 1-3 years and should not be subject to retirement account rules. Annuities are best for longer-term savings goals and, due to their tax-deferred status and requirements for withdrawal only after 59.5 years old, meant primarily for retirement savings.
Stephen Kates, CFP®Founder of Clocktower Financial ConsultingStephen Kates is a Certified Financial Planner™ and personal finance expert specializing in financial planning and education. Stephen has expertise in wealth management, personal finance, investing and retirement planning.
How To Choose Between an Annuity and a CD
When deciding whether to put your money in an annuity or a CD, you must carefully consider your circumstances and investment objectives. Also consider your tolerance for risk, which depends largely on your time horizon.
If you plan to use the money invested to generate a predictable stream of income for retirement, an annuity is the appropriate choice. However, if you are just looking to produce some extra income on your excess cash, a CD is the better option.
Other considerations that will help you make an optimal decision include:
- Are you intent on having your investment insured by the federal government? Or, are you comfortable having it backed by a reputable insurance company?
- How long are you willing to lock up your money?
- Are there specific annuity riders that appeal to you?
- How diverse is your investment portfolio and which of these vehicles best complements your holistic strategy? Does investing some money in both instruments make sense?
As you evaluate these ideas, enlist the help of a fiduciary financial advisor. He or she can provide invaluable guidance regarding investment selection decisions and a myriad of other matters.
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Frequently Asked Questions about Annuities vs. CDs
CDs and annuities are both safe investments. However, given their federally insured nature, CDs are generally considered to be safer than annuities. That said, annuities issued by financially sound insurance companies are among the safest instruments in which you can invest.
Generally, fixed annuities are the safest type of annuity because they offer stable, guaranteed rates of interest. Indexed annuities are riskier because their returns can fluctuate. Variable annuities are the riskiest type of annuity due to the fact they entail investment positions in volatile assets, such as stocks and bonds.
Some CDs make periodic interest payments throughout their terms. However, zero-coupon CDs do not make any interest payments. Rather, at maturity, these instruments compensate investors by paying out more than the initial investment.
Editor Malori Malone contributed to this article.
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