Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Annuities and certificates of deposit (CDs) represent different ways to save money, for retirement as well as other goals. Both savings vehicles give you the possibility to earn a higher return on your money than just parking your cash in a standard savings account.
While both types of products may help you grow your nest egg, the way they accomplish this goal isn’t the same. Let’s review the key similarities and differences between annuities and CDs, along with the pros and cons of each account.
Annuity vs CD: What’s an annuity?
An annuity is an insurance product you can purchase to help secure steady income during retirement. You can purchase an annuity from an insurance company, either all at once — as a lump-sum annuity — or by making a series of payments. In exchange for your money, the insurance company promises to make payments back to you, typically a portion of your initial investment plus interest, starting either right away or at some point in the future.
The term of the annuity lasts either for a set period of years (say a 20-year term), or until the death of the holder (and in many cases, the death of the holder’s spouse, and sometimes even longer).
“There are several types of annuities, but the most basic form provides a stream of payments over the holders’ lifetime,” said Brandon Renfro, Ph.D, a financial advisor and assistant professor of finance at East Texas Baptist University. “Annuities are very good for providing an income floor in a retirement plan. For one fixed amount, you have a known income stream that is guaranteed for life.”
The three most common types of annuities are as follows:
- Fixed: An insurance company agrees to pay you a minimum interest rate on your investment, specified up front.
- Indexed: The return you earn on your investment is based upon an index, like the S&P 500.
- Variable – Choose from a range of investment options, often mutual funds. The payout you receive in return varies based upon how much you invest and how your investments perform over time.
Ken Tumin, founder and editor of DepositAccounts, says that “for those looking to annuities as an alternative to CDs, the fixed annuity would be the most appropriate type.”
There are similarities between annuities and CDs. Both can pay you higher returns than standard bank accounts, and to earn the higher potential returns, you’ll have to be willing to stash away your money and agree not to withdraw it for a set term. If you change your mind and want to withdraw your money early, you could face steep penalties with either product.
Annuity vs CD: What’s the difference?
Despite a few similarities, CDs and annuities have several key differences, from how your money is backed to how you’re paid on your investment. A few key differences between an annuity vs a CD include:
- The payments you may receive aren’t the same. Annuities grant holders regular payments that include a portion of principal plus earned interest. CD payments, if selected as an option, only consist of earned interest, with the principal remaining untouched until the CD matures.
- CDs and annuities are taxed differently. Interest from both annuities and CDs is taxed as regular income. With CDs, the principal is never taxed. But annuities purchased with pre-tax money out of an IRA have all payments — principal and interest — taxed as regular income. A set portion of the payouts from annuities purchased with after-tax money are taxed as regular income, and a portion is not taxed.
- Your money isn’t insured in the same way. The money you put into a CD is insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC). Fixed annuities are insured by state guaranty associations, with varying rules.
Annuity vs CD: Pros and cons
Both annuities and CDs have their own pros and cons, concerning taxes, insurance and transparency:
CD pros and cons
|CDs are FDIC insured, meaning that the federal government will back your deposit up to $250,000 if the financial institution holding your money should fail.
|CDs may have lower payouts when compared with annuities with similar terms. The average 5-year CD rate is currently around 2.25%. Some annuities (specifically SPIAs) could offer you a payout rate over 4%,so you might earn less when investing your money with a CD.
|CD features are typically more transparent and easier to understand when compared with annuities.
Annuity pros and cons
|You pay taxes only on earnings when you receive payments if the annuity is bought with after-tax funds. If you buy with pre-tax funds, taxes are paid on earnings and principal.
|Annuities aren’t backed by the FDIC. Instead, they’re backed by the insurance company that issues them to you.
|Early withdrawals can be expensive. You may be charged high surrender fees by the insurance company, plus you may face tax penalties as well.
|The features of annuities aren’t always as transparent or easy to understand as CDs.
Annuity vs CD: Which should you choose?
When weighing an annuity against CD options, it helps to identify your goals first. Because of the risks, tax implications and potential returns involved, this is a much more complicated decision than, say, choosing which bank account has the best new sign up bonus.
Annuities typically work best for people who are saving for long-term goals, such as retirement. Depending on the type of annuity, you could be charged high taxes and penalties if you withdraw your money from an annuity too early. If you’re saving for a shorter-term goal or are uncomfortable with the risk of annuities, a CD may be the better choice for you.
However, with greater risk may potentially come higher earnings. The guaranteed income stream of annuities is also an appealing feature to many people.
If you do opt to buy an annuity, it’s important to make sure you’re dealing with a registered insurance broker. The SEC recommends checking with your state insurance commission to confirm your insurance broker is registered to sell in your state of residence.
To mitigate your risk, it’s also wise to check out the strengths and weaknesses of an insurance company before buying any new annuity. This can be accomplished by requesting a report from an independent financial rating service like Moody’s, Fitch, Standard & Poor’s, or A.M. Best. You may also want to review ratings from more than one company since the reports from various rating services don’t always agree.
Finally, when your weighing out annuity versus CD options, remember there’s also no reason why you can’t diversify your investment strategy to include both of these savings vehicles.
Annuity vs CD: The bottom line
Annuities often make people nervous, sometimes for good reason. Annuities are less understood and may also get a bad rap because of bad actors in the industry. However, that’s not necessarily a reason to dismiss them as an option out of hand.
Sean Gillespie, Co-Founder and Partner at Redeployment Wealth Strategies, a fee-only Registered Investment Advisor in Virginia Beach, maintains that “annuities should not make people nervous...but annuity salespersons should.”
Tumin also encourages caution when dealing with annuity salespersons stating, “many annuities have very large commissions and expenses with terms that can be very unfavorable to the customer. These types of annuities are often heavily pushed by commissioned salespeople.” Yet Tumin goes on to state that, “it’s important to note that there are a few annuities, like SPIAs, that can be a reasonable option for certain people.”