Comparing Tax-Deferred Annuities to Certificates of Deposit
One of the basic questions that new savers ask is how they can compare the aspects of a tax-deferred annuity to a certificate of deposit (CD)? While both are what I call financial foundation products that are purchased as safe money solutions, they have fundamental differences that need to be addressed in the buying process.
Which Product is the Right Choice?
In different situations, both can be the right choice. When it comes to your needs, it is important to determine whether you need ready access to your money for short-term goals or need to put funds away for longer-term goals.
Safe money is the money you don’t want to take the chance of losing. Both annuities and CDs are great safe money places for your savings nest egg dollars. When it comes to which one is better, the answer depends on your individual financial situation and objectives. This Moneysavers post offers a short snapshot of the key characteristics and differences of each type of product.
Certificates of Deposit (CDs)
A CD is a type of savings account found at banks, credit unions, and other financial institutions that offers interest rates locked in for a specific period of time.
CDs attract individuals who are looking for a safe place for their money. These people are usually more concerned with the return of their money rather than the return on their money. Most CDs are issued by a bank or credit union and guaranteed by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Share Insurance Fund.
CDs typically range in duration from 3 months to 5 years and guarantee a specific interest rate for the term chosen. Generally, the shorter the duration, the lower the interest rate. The typical time period selected is 1-3 years, and interest rates will differ depending on market conditions when the CD is purchased. At maturity, owners must decide whether to accept a new guaranteed interest rate and duration period or move the money. If no action is taken, the financial institution will usually automatically renew the CD for the same duration and lock in the interest rate in effect at that time.
If the purchaser of the CD looks to withdraw the money prior to the agreed maturity date, the bank will usually charge an early withdrawal penalty of a minimum of 6 months interest or greater.
An annuity is an insurance product you can use to accumulate funds for retirement and other long-term objectives. It is a contract between the purchaser and the life insurance company where money is paid to the insurance company now in exchange for a lump sum or income payments at a later time. Interest earned on money held in a deferred annuity is not taxed until withdrawn.
An annuity is not insured by any government agency; rather, annuity guarantees are based on the financial strength and claims-paying ability of the issuing life insurance company. Financial strength ratings issued by independent reviewers as well as the annuity’s features play an important role in the selection of one contract over another. In the event of the insolvency of an insurance carrier a number of states have set in place some financial protections. Please go to the National Organization of Life & Health Insurance Guaranty Associations for more information.
Most annuities are designed with surrender or withdrawal charges and accumulation strategies that range between 5 and 10 years in duration. While some may have rate guarantees that extend beyond the first contract year, most offer attractive first-year interest rates with renewal rates that change annually in years two and beyond. These renewal rates will never fall below the minimum guaranteed interest rate declared in the annuity contract, and many annuities can have renewal rates that are higher than the minimum interest rate guarantee.
Unlike CDs, annuities usually allow for free withdrawals of only a portion of the contract value after the first year. (Note: withdrawals may be taxable and excess withdrawals may incur withdrawal charges.) Another benefit for most annuity owners is the potential to avoid the costs, delays and publicity of probate, as death benefit proceeds are passed directly to the named beneficiary.
Short-term or Long-term Savings Goals
The key factor in the decision to purchase an annuity or CD should be whether the money is intended for short-term or longer-term goals.
CDs are generally considered short-term vehicles and are used for such goals as saving money for a new car, getting a higher return on a portion of your emergency fund, or creating a down payment on a house. CDs work well for these goals due to their short time periods.
Annuities are typically chosen with the intention of holding the contracts for longer periods of time. They are generally used to help save for later in life such as for retirement or to protect money that has already been accumulated for long-term goals. Although annuities are considered long-term vehicles, once the withdrawal or surrender charge period has been satisfied, they are free of any new withdrawal charges and can provide liquidity as needed.
The Tax Difference
While the length of the duration period is a key factor, it’s easy to see the biggest difference between the two products comes down to taxation. Earnings on CDs are taxed annually. With an annuity, interest earnings are not taxed until withdrawn.
Unless the CD is held in a qualified account such as an IRA, interest earnings in a CD are reported annually and income tax must be paid on the earnings each year, even if funds are not withdrawn from the account. Interest earnings in an annuity are taxed during the year they are withdrawn and subject to your income tax rate at that time.
It may seem like a simple point, but the difference between a tax-deferred product and a taxable product can be considerable. Money can grow faster in a tax-deferred product like an annuity because interest compounds on top of the money ordinarily paid in current income taxes. A tax-deferred product may outperform a taxable one because there are three components at work:
The premiums earn interest
The interest earnings on the premiums earn interest
And most importantly, the money you are not paying in current taxes earns interest
Access to Your Money
The way money is paid out from these products is also an important factor to consider. At the end of an annuity’s accumulation or growth period, an owner can opt to keep the money in the annuity for continued growth, take a lump sum amount, or chose to take income over a selected time period, including their remaining life. The ability to generate guaranteed lifetime income is one of the key advantages to tax-deferred annuities. There is also a 10% Federal penalty tax for withdrawals from annuity contracts prior to age 59 ½.
With a CD, the owner can take a lump sum distribution, renew the CD at a current or promotional renewal interest rate, or look at other accumulation alternatives. CD renewal rates are not guaranteed at the time of the original transaction and there are no income options available.
Additional Optional Benefits of Tax-deferred Annuities
The majority of tax-deferred annuities are purchased with optional benefits provided by insurance companies that are not available from banks or other financial institutions. These optional benefits usually provide guaranteed lifetime withdrawal amounts, enhanced death benefits, long-term care coverage options, nursing home care payments and special withdrawal benefits in case you become terminally ill, some of these options come with an additional annual cost.
The most popular annuity benefit option chosen by consumers is the guaranteed lifetime withdrawal benefit. This benefit gives you the option, which you can choose to stop and restart, to withdrawal a certain percentage of your annuity’s value each year for as long as you live without the concern of running out of money. For example, if your annuity has an available amount of $100,000 you may have the contractual option to withdrawal 4% of this amount each year for the rest of your life starting at age 65. Insurance carriers charge separate fees for these additional benefits and mandate at which ages and the percentages available for withdrawal as detailed in the annuity contract. You will need to clearly understand the optional benefits offered by the annuity company you are considering along with the charges and conditions they require.
Certificates of deposit and tax-deferred annuities are two of the most common safe money products you will encounter for your savings. This post has been prepared as general information regarding these products. This is just a few of the reasons to consider if an annuity or a CD is right for you. It is intended to be an overview and not to serve as a comprehensive analysis of these two types of savings products. Please consult your qualified financial professional regarding your specific situation before buying any product.