If you want to invest your funds in something other than a 401(k) or IRA, should you choose an annuity or certificates of deposit? Both are insured, and both offer a set return. What are the differences, and which should you choose?
Annuity or Certificates of Deposit?
To choose wisely between an annuity or certificates of deposit, you should understand how they work and their characteristics.
How Annuities Work
Annuities are insurance contracts issued by institutions. You purchase or contribute to them with a lump sum or monthly premium. This money is invested, and at some future time, the institution begins issuing regular payments, either for a fixed period or for the rest of your life (the annuitization period).
Characteristics of Annuities
Annuities are usually insured by the company issuing them and often by state guaranty associations.
Early withdrawal from a fixed annuity attracts penalties, although many types permit you to draw up to 10% per year without a penalty. Withdrawing before you are 59.5 years old has tax implications.
They offer higher interest rates than certificates of deposit, making them better for safe, long-term investment. However, the rate of return may still not track inflation.
Interest earned by your annuity is tax-deferred, meaning that money that would have gone as tax can compound, resulting in greater returns. When you start withdrawing, you are taxed at the standard rate. If you funded it with after-tax dollars, you get the principal free of tax.
In most states, they are safe from creditor liens. Depending on the options provided by the insurer, you may be able to obtain the following:
- Higher payouts if the value of the underlying securities increases while guaranteeing a minimum benefit.
- Joint-survivor clauses that provide for your spouse after your passing
- The option to leave some of the principal to heirs other than your spouse without probate costs.
- Catastrophe withdrawals, e., the ability to draw a large lump sum for emergency expenses.
They guarantee regular payment throughout the annuitization phase.
Best for: Supplemental long-term investment for retirement to avoid running out of funds.
How Certificates of Deposit Work
Banks and credit unions offer CDs. When you take one out, you sign an agreement to leave your money in this account for the entire term of the CD in exchange for a set interest rate, protected from fluctuations of the Federal Reserve’s rate. Once the time is up, you can withdraw the lump sum from the account or reinvest it in another CD.
Characteristics of CDs
If you take out a CD from a bank, the FDIC insures it, whereas the NCUA covers credit unions. Either way, your funds are protected by the federal government up to $250,000.
If you need to draw early from a CD, you will pay the penalty, but a lower one than an annuity.
Certificates of deposit generally offer pretty low-interest rates; investing in a CD is more worthwhile when federal interest rates are high, and shopping around may yield a better return. A step-up (bump-up) CD allows you to take advantage of increases in the federal interest rate.
CDs don’t attract tax on the principal, but any interest earned is subject to annual income tax.
They are generally exposed to creditor liens and judgment. In the event of your passing before its maturation date, your named beneficiaries will only receive what is left after any debts on the estate have been paid and will experience a delay and probate costs.
Best for: Low-risk investment for medium-term goals such as a down payment on a house.
When choosing between an annuity or certificates of deposit as investment instruments, you should primarily consider the purpose of your investment. The characteristics of annuities make them most suitable as backstop investments to guarantee income in retirement. Conversely, CDs are better for saving towards medium-term expenses.