Why Choose an Annuity vs. a CD?
Annuities and certificates of deposit often end up in the list of suggestions for low-risk retirement income streams. The reasons for choosing an annuity vs. a CD vary depending on your financial goals, and in rare cases, a CD might make more sense.
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Annuities work similarly to Certificates of Deposit (CDs), but they have different crediting methods and interest rates.
Banks offer CDs. You deposit a chunk of money into an account for a set interest rate for a set length of time. Most start at a year, but you can go up to 5 years. Interest rates vary, depending heavily on the economic cycle.
Right now, interest rates on CDs could be called abysmal, and that would still be generous. On the high-end, banks offer 0.65% to 1% percent interest on 5-year terms.
An annuity is an agreement with an insurance company. You give them a specific amount of money, and they give you another set amount later. Annuities offer more variety in their payouts. You can choose a lump sum or get a fixed amount each year for the rest of your life.
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Rates of Return on CDs vs. Annuities
The longer the annuity has to accumulate interest, the higher the rate of return. It works the same way with CDs. The longer you promise your money to the bank, the higher the interest.
Currently, most CDs hover around 0.15% return for a 1-year term. You might get close to 1% if you have a great bank and choose a long-term length – say 5 years.
Annuities currently run between 2% and 3% for even shorter lengths. Again, the longer you go, the higher the interest.
However, it’s in your best interest to treat this like car shopping. You don’t just take the first offer that comes up. You look around to find the right features for your financial situation, and then you choose the option with the best rate of return.
Abrams Insurance Solutions represents 30+ of the leading annuity companies. Give us a call and we will shop all of our companies to find you the best rate on your annuity.
A better interest rate is the obvious advantage here. If you give me $5 and can choose whether I give you $10 or $15 back in a month, you will pick the $15. It’s straightforward math. When you invest your money – particularly when focusing on retirement and not outliving your money – better interest rates will mean you have more cash. Easy.
Annuities are tax-deferred. CDs are not. Each year, you will owe the IRS money on whatever interest you get out of your CD. With an annuity, you won’t pay anything until the annuitization period begins. Then you will only pay on the interest.
With an annuity, you won’t pay any tax until you take money out of your annuity.
Annuities can be held inside of a Roth account. An annuity inside a Roth will mean tax-free money for you when you retire.
Annuities offer better liquidity options. Should a catastrophe occur, you can sell your annuity. Just like you can sell a life insurance contract you no longer need, there is a whole industry around investors buying up unneeded insurance products.
This way, the original owner doesn’t lose all of the money they’ve paid in. It prevents what investors call the ‘sunken cost fallacy’ or, as your grandparents might have phrased it, “throwing good money after the bad.”
Banks also charge you an arm and a leg if you want to take your money out of your CD early, say to cover an emergency medical expense. However, insurance companies allow you to withdraw either interest or a small portion of the annuity value early without penalizing you. It offers a little more flexibility for emergencies.
If you think this strategy might be wise for you, consult a tax professional first to confirm all of the numbers.
Some annuities also offer extra benefits like a death benefit or financial assistance with long-term care needs. If your life insurance has expired or you never had any, this can bolster your finances during your golden years or leave something for your heirs in addition to guaranteed income for life.
The main reason people choose annuities comes from a guaranteed income for as long as you live, or income for a surviving spouse. It’s one of the few ways to ensure that you never outlive your money.
It wouldn’t be a fair shake for CDs if we ignored their advantages over fixed-rate annuities.
The first regards retirement. Withdrawing money from an annuity before you’re 59.5 years old incurs IRS penalties. Annuities are supposed to be retirement vehicles, so just like your IRA or 401(k), you get penalized for pulling money any younger.
CDs are not retirement vehicles, and therefore the IRS doesn’t care what age they mature or what age you withdraw early – however, early withdrawal penalties from your bank may still apply.
The other advantage CDs have over fixed-rate annuities is they’re FDIC insured. That’s the government saying they’ll cover you up to a certain dollar amount if the financial institution goes bankrupt. It’s a remnant from the banking disasters in the 1920s.
Because annuities come from insurance companies, they don’t fall under the FDIC coverage. However, most states have various guarantee programs that offer similar safety for annuities if an insurance company goes under without selling its book of business.
Pre-retirement consideration between CDs and Annuities
Honestly, if you’re in your 30s or 40s, there are better retirement savings vehicles. You will get higher potential rates of returns in more traditional qualified methods. The biggest thing here is when you’re younger, you have time – time to earn more, time to invest more, and (most importantly) time for compound interest to work its magic.
The older you get, the less time you have to make up for investing mistakes – making more conservative investment decisions the safer choice. Unless the providing institution goes out of business, you cannot lose money with a CD or fixed-rate annuity – making the one with higher returns the better choice.
CDs can work well for short-term goals, like saving for the downpayment on a house. You can choose to put it in for a year or two, getting more interest than you would from your bank. The early withdrawal penalties remove the temptation to pull cash out early for an impulse purchase.
Plus, you can always roll your 401(k) into an annuity later.
Post-retirement consideration between CDs and Annuities
Since an annuity will pay you for the rest of your life (usually in monthly installments), you will never run out of money. Most annuities also give the option of paying in a second survivor method too.
For example, if you’re married, have an annuity, and pass away before your spouse, many annuities will continue the monthly payments for the rest of your spouse’s life too.
If you want a monthly or annual income from your certificates of deposit, you would need to manage what investment professionals call “CD laddering.” You maintain multiple CDs with maturity dates whenever you want a new payment.
For example, for ease of explanation, let’s say you need $80,000 a year. A 5-year CD will give you the best interest rate, so you calculate how much you need to put in to get back $80,000 in 5 years.
Every year, you need to look at the interest rates, calculate the principal amount you invest, and then wait for maturity. With annuities, you can set it to pay out each month or each year from just one annuity, and you’re set for life.
You can also ladder annuities if you’ll need different amounts of income over time.
Other Annuity Options
Fixed annuities are the safest choice as far as not losing your principal in an investment. But all investments follow the low-risk, low-reward guidelines. Anything claiming otherwise is either remarkably complicated or involves someone with a dubious moral compass.
You can increase your potential profits (and risk) through fixed-indexed or variable annuities. Variable annuities invest your money in an index, like the S&P500. You can gain more money on good years in the market, but you also suffer the crashes and corrections.
Fixed-indexed annuities are hybrids of the two types. They limit your risks, but may also limit your returns.
Choosing between an annuity vs. a CD boils down to the interest rates at the time. It doesn’t look like banks are going to be offering great rates in the near future, but nobody can know for sure.
CDs can be great when interest rates are higher or an annuity doesn’t make financial sense. But those scenarios are going extinct in favor of the better rate of return on annuities.
However, annuities offer more customization through more complicated financial mechanisms. Read up on annuities, read the fine print, and have confidence in understanding how any financial product works before putting your money with it.
How Abrams Insurance Solutions Can Help
At Abrams Insurance Solutions, we help families build a strong financial foundation that the rest of their life may depend upon. Retirement planning involves a long journey, and protecting it during retirement years is one of the final steps.
We make it our mission as a small, family-run agency to find you the best return rate for the lowest possible out-of-pocket amount. Give us a call today at (858) 703-6178 to see what kind of returns you can get on an annuity to fund your retirement.