Comparisons are often made between annuities and Certificates of Deposits (CDs). Yet there are stark differences between the two, which can have a profound impact on the investor’s finances. A CD is issued by a banking institution or credit union whereas an annuity is issued by an insurance company. A certificate of deposit allows the investor to invest their money at a fixed rate of interest for a particular period of time, for example, between six months and 10 years.
The money deposited in the CD can accumulate at a fixed rate of interest for the life of the CD and compounded on a daily basis. The money earned over the course of the year is perceived as income and is taxed at the investor’s current tax bracket. Depending on the banking institution there are varying degrees of penalties for an early withdrawal, but they are usually minimal. Some banks, for example, will subtract a month’s interest earned for an early withdrawal. Once the CD has reached its maturity date, a CD can then be either withdrawn or reinvested into another CD for a particular period of time. There are no age restrictions for withdrawing money from a CD, either before or after its maturity.
An annuity is a financial vehicle and contract that promises to make payments to the investor periodically, for a predetermined amount of time; it is often sold or backed by an insurance company. CDs are specifically compared to “fixed” rate annuities, as fixed annuities are also established for a specific period of time, in which they are set to grow at a “fixed” rate of interest. There are, of course, a variety of annuities that exist, such as variable or indexed annuities that do not provide a fixed rate of income.
The differences really stop there as annuities can deliver an often higher rate of return to their owner when compared against the rates of CDs or similar savings vehicles, such as money market accounts. With fixed annuities, we find other important groups that require some understanding. For example, “immediate” or “deferred” fixed annuities are viable options here as well. The “immediate” group provides a “fixed” payout which is established on the actual amount of the initial investment depending on the age of the investor.
With the predictable fluctuations in the market, fixed annuities have attracted the attention of many investors due to their level of stability. Fixed “deferred” annuities are investments vehicles that grow at a fixed rate, but defer or “put off” taxes that is earned on that growth until the investor is ready to make a withdrawal. Say, for example, a 40 year old man, just inherited $200,000 from his father. If he put that money in a deferred annuity, say for twenty years, he would be able to grow that account and not be taxed on that growth until he makes the very first withdrawal. In the mean time, each year, the annuity would grow about 3% a year – essentially tax-free. This allows the 40 year old man to essentially earn a future income without receiving a 1099 every year.
The predictability of performance and their ability to protect against taxation make fixed annuities make them particularly attractive to anyone’s retirement income portfolio. CD accounts issued by a bank or credit union are back by the FDIC. Annuities, issued by insurance companies, are not backed by the federal government. Though risk is always a factor to be considered, fixed annuities are often backed by the state group. In addition, other insurance companies would step in to buy the annuities from the company moving into insolvency.