CD Vs. Fixed Annuity
When you are investing for retirement, you have many choices open to you. If you are a conservative investor, you'll want to stick with investments that pay a guaranteed rate of return. Two such investments are bank CDs (Certificates of Deposit) and fixed annuities. Make sure you understand the differences between these investment products before you invest in them.
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Function
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A bank CD functions by accepting deposits from you and investing this money or loaning it out to borrowers. The CD represents a time deposit. You lend the bank money for a set period of time, and they pay you interest on that money. When the term of the CD is over, the bank returns your original investment amount.
A fixed annuity functions by accepting a deposit from you (called a premium) and investing that deposit into bonds and other income producing assets. The annuity is then credited with the interest generated by the investments. In this way, a fixed annuity functions like a long-term savings account that is held with an insurance company for the purposes of accumulating a retirement savings.
Significance
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The significance of a bank CD is that the CD is a deposit with a bank. When the CD term is up, you may invest in another CD or take the money and invest in something else entirely. The interest on the CD is taxable in the year it is earned. The significance of an annuity is that interest is tax deferred until you withdraw money from the annuity. Annuities are considered non-qualified retirement accounts by the IRS, however, which means that you may not withdraw money from the annuity prior to age 59 1/2 without a 10 percent penalty being assessed against your withdrawal.
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Benefits
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The benefit of a bank CD is that it is guaranteed by the bank you are doing business with and is insured by the FDIC. The benefit of a fixed annuity is that the funds are guaranteed by the insurer you are doing business with and is guaranteed by the State Guaranty Association in the State where you live. The FDIC and State Guaranty Association ensure that funds are available to pay the promises of your bank or insurer if your bank or insurance company fails.
Disadvantages
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The disadvantage to a bank CD is that if you cancel your bank CD before the CD has matured, there is normally a penalty associated with the early liquidation. Penalties are typically three months worth of interest. Additionally, all interest earned is taxable as income. If the interest is substantial, this could put you into a higher marginal tax rate thus increasing the amount of income taxes you pay on all of your income. The disadvantage to an annuity is that it is a long-term contract. If you need your money prior to age 59 1/2, there really aren't any options to access the funds without paying a penalty.
Considerations
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Consider buying a CD inside of an Individual Retirement Account, or IRA. IRAs defer taxes on investment earnings. This means that your bank CD could be used as a way to conservatively build wealth over time similar to an annuity. Consider an annuity if you need all of the benefits of a bank CD but also need a guaranteed income you cannot outlive. Fixed annuities can guarantee you an income during retirement for the rest of your life or for a set period of time. Annuities are also ideal for long-term savings due to their relatively illiquid nature until you reach your normal retirement age.
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