CD’s vs. Annuities (plus an infographic!)

I’m always suspicious of those magazine ads selling socks or sweatshirts that say “one size fits all.” I’m a pretty big guy, with 50-inch shoulders, that still plays rugby with “The Old Boys Club.” My brother is tall and a little on the thin side. The point is, there’s no way the two of us can fit into the same size of anything. Not a sock, a sweatshirt, or even the same sports car.

Yet I hear this type of thinking all the time in my practice. “My cousin got this stock market fund, so that’s what I’m going to buy as well,” or “I’ve heard CD’s are a bad place to put your money,” or “I heard you should never buy a fixed annuity.”

The truth is, investments are like clothes. One size just doesn’t “fit all.”

CD’s vs. Annuities

Dear FedNav,

I am 62 years old and I have almost $100,000 to invest. I am very financially conservative and do not want my money in the stock market. I can live off of my pensions, so unless something unexpected comes up, like needing a new car transmission or having to go to a nursing home, I probably won’t need the money. I’d really like it all to go to my kids. My banker suggested a CD, while my insurance agent suggested a tax-deferred annuity. Who’s right?

Dazed and Confused, Howard County, Maryland

Dear Dazed and Confused,

You stated that you probably won’t need the $100,000 for the rest of your life, except in case of an emergency or unexpected expense. Otherwise, you want it all to go to your kids. We typically recommend that retirees keep enough to cover three months of expenses for emergencies, like that broken transmission or a leaky roof. So, calculate three months of bills and set that amount aside in a savings account. Just keep it in your bank. After you’ve done that, the rest is eligible for long-term savings.

Long-Term Savings: CD’s vs. Annuities

First, let’s discuss the advantages and disadvantages of two popular long-term savings vehicles: CD’s and tax-deferred fixed annuities. Then we can look at some specific differences between the two.

CD: Advantages

  • CD’s are insured by the FDIC, just like any bank account under $100,000. But unlike bank accounts, the maximum insured amount is $250,000. In other words, your principal isn’t going anywhere, as long as it is under $250,000.
  • They have very low minimum initial deposit amounts and are easy to set up. You don’t need to invest all your money to start one. You can usually just walk into your bank and ask about CD’s.
  • CD’s have a steady rate throughout the life of the account, meaning that the rate of return will not change if the market goes up or down.

CD: Disadvantages

  • CD interest counts as taxable income. So by having your money in a CD, you won’t be reducing your tax burden. If you keep it in there long enough to collect significant interest, you will see your taxable income go up.
  • If your money is in a CD, you’ll want to keep it there for a while before taking it out. The reason for this is twofold. First off, the interest rates, although typically better than a savings account, are not high. The money will need to be there for a while before it actually grows. Second, if you take money out early, you’ll be subject to early withdrawal fees, which will end up costing you a substantial chunk of the interest you earned. The longer the term, the higher the interest rate, so if you don’t want your money locked up for a while, a CD may not be the best choice for you.
  • Inflation can get to it. The interest you earn may not end up meaning much, because if inflation rises, your money will lose purchasing power if the CD rates fall behind inflation.

Fixed Annuity: Advantages

  • Fixed Annuities are tax-deferred, so the interest you earn will not be taxed while it is growing in the account. Once you start receiving installments from the annuity, however, it will be taxed as income.
  • Like CD’s, if the market goes down, you can count on a fixed interest rate. But if the market goes up, you don’t get a benefit from it out of the annuity.
  • In the event of your death, your children (if they are named the beneficiaries) can inherit the annuity, which would then give them the remaining money in the account, like life insurance. The money will be taxed as income, but this will avoid putting time and money into probate.
  • Fixed annuities are often a reliable, conservative option for investing, which is why so many people use them in retirement.

Fixed Annuity: Disadvantages

  • While most annuities allow a certain amount of withdrawal, you will get hit with some heavy surrender fees if you take money out early, and the money will be taxed as well. So if you put money into an annuity, you have to be okay with it being in there for a long time.
  • Payments may not keep pace with inflation. Like the CD, the rates and payments are going to stay the same the whole time. So if the dollar inflates, your interest is not going to be any higher.
  • While some annuities have guaranteed rates throughout the term of your contract, others have a fixed rate for a certain amount of time, and then they will change. If you don’t like the new rate, and choose to take money out, you will be hit with the surrender fees.
  • The guarantee of an annuity depends on the ability of the issuer to pay, so you may end up being owed some money if the company has too many people collecting money from annuities.

So… What’s the Difference?

So now you have a lot of information about the advantages and disadvantages of annuities and CD’s. But what are the differences?

  1. CD’s are taxable income, whereas the money in an annuity is not taxable until you get it back (tax-deferred).
  2. If you withdraw from a CD early, you’ll probably lose almost all of your return. Someannuities, on the other hand, let you withdraw annual amounts penalty-free. Other annuities will hit you with an early withdrawal fee AND 10% tax.
  3. Annuities are more like insurance policies, while CD’s are more like savings accounts with some more interest (this comparison is GREATLY simplified though, and there are many factors that need to be considered).
  4. Annuities can be inherited by your children, but will be counted as taxable income. CD’s, on the other hand, will probably have to go through probate (an annuity does not always have to), and only the interest will be taxed as income.
  5. CD’s typically have much lower interest, as well as lower investment minimums.
  6. Since an annuity is a retirement account, you may have to leave the money in there for a longer period of time than with a CD, which will be available after a set period of time.
  7. CD’s are insured by the FDIC up to $250,000, while annuities are backed up by each state’s guarantee funds.
  8. Interest rates can be changed (dropped) in annuities by the company after a certain amount of time, whereas CD’s have rates for a certain period until they roll over to a new rate, so it generally increases with extended periods of time.

In the end…

Really, both fixed annuities and CD’s can be safe, reliable ways to hold and grow your money. It takes a case-by-case assessment to determine what will be better for you, and it’s definitely worth talking to a professional.