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Annuity vs. CD: What’s the Difference?

Annuity vs. CD: What’s the Difference?
22 Jul
6:39

Saving money for the future while growing your nest egg is the core of all financial planning. Developing a portfolio of investments that ensures a strong financial future can be complex, however. Between savings accounts, stock options, bonds, individual retirement accounts (IRAs) and 401(k)s, there’s a lot to consider.

Among these great options are also annuities and certificates of deposit (CDs). Let’s take a closer look at these two products, define how they function and help you decide which one you should choose as part of a solid savings plan.

Annuity vs. CD: What is an annuity?

An annuity is a financial contract between you and an insurance company, primarily used to save for retirement. Annuities assure retirees a fixed stream of income. When working with annuities, you make contributions in a lump sum or through a series of payments. From there, the insurance company will disburse periodic payments beginning at a predetermined date, whether immediately or years down the line.

Annuities are usually sold by an insurance company, which takes your money and invests it for you. Your funds accrue interest over time and grow tax-free, which means you won’t have to pay any taxes on gains from the investment until you withdraw the funds. When you take distributions from an annuity, they are taxed as regular income.

There are three types of annuities — fixed, indexed and variable — and two ways to receive distributions — immediate annuities and deferred annuities. Immediate annuities begin paying you benefits as soon as you fund them, while deferred annuities don’t begin distributing benefits until a future date. Both varieties pay out on a regular basis, and some offer death benefits. If you die before the total annuity has been paid out, a beneficiary may continue to receive payments.

Fixed annuities

Fixed annuities guarantee a minimum interest rate and a fixed number of payments over time. The annuity provider is required to make these payments in a specific dollar amount. You’ll be able to agree to receive payments over an agreed-upon amount of time — 15 years, for example — or for the duration of your lifetime or a beneficiary’s lifetime. Fixed annuities are regulated by state insurance commissioners.

Indexed annuities

Indexed annuities distribute payments to you based on the performance of a stock market index, typically the S&P 500. The annuity provider delivers a payout minimum determined at the time investment, no matter the performance of the stock index over the course of the investment period, plus additional amounts when the index performs well. When the index doesn’t perform well, all you get is the minimum payout. Indexed annuities are regulated by state insurance commissioners.

Variable annuities

Variable annuities offer greater flexibility than fixed or indexed annuities. You may choose to invest your payment into a range of investments, most typically mutual funds. Your payouts and payment periods will differ based on the size of your investment, expenses incurred and investment option’s performance over the course of the investment period. These are regulated by the Securities and Exchange Commission.

Annuity vs. CD: What is a CD?

CDs are offered by banks and credit unions, primarily to save money for short- and medium-term goals. With a CD, you agree to place a fixed amount of money into an account for a set amount of time, called a term, lasting from three months to 10 years. Each financial institution offers different rates for CDs, and the interest paid out generally compounds over the term of the CD. The financial institution pays interest on the CD principal, but the interest is only accessible and paid out to you once the term of the CD is complete.

After the term of the CD ends, you withdraw your funds plus the interest that has accrued. You can purchase CDs through federally insured banks, which insure the investments up to $250,000. This Federal Deposit Insurance Corporation (FDIC) insurance combined with the steady interest growth make CDs one of the safest options for those looking to save for their future.

Annuity vs. CD: What are the differences?

There are key differences between annuities and CDs. First and foremost, these two financial instruments pay out very different amounts on very different payment schedules. When investing using annuities, you’ll have the option to receive regular payments over time, which may include part of the principal investment as well as interest earned. In all but a few cases, CDs pay out principal and earned interest only at the end of the term, once the CD matures.

CDs and annuities are insured differently. The FDIC insures CDs up to $250,000, while fixed and indexed annuities are regulated by state insurance commissions. When buying an annuity, you must research whether your state has a guarantee association that provides some level of protection for when an insurance company in that state fails. Also note that variable annuities are considered to be a security, and as such, are regulated by the SEC. Variable annuities are covered by the Securities Investor Protection Corporation (SIPC).

You need to consider the differing tax treatment of annuities versus CDs. While interest from both investment vehicles are taxed as regular income, the principal from a CD is never taxed. However, with annuities, both the principal and interest are taxed, even when purchased with pretax funds out of an IRA. A set amount of an annuity’s payout that was purchased with after-tax dollars is taxed as regular income, while another portion is not subject to taxes. Annuities offer tax-deferred growth, however, which means you won’t have to pay any taxes on growth until you withdraw the money.

Breaking Down Annuities vs. CDs

Annuities CDs

Payment

Receive portion of principal investment and interest in regular payments over time. Receive a single payment of principal and interest once the CD has matured.

Insurance

Varies on a state-by-state basis, depending on the rules of each state’s guaranty association. Insured by FDIC up to $250,000.

Taxation

Portions of both interest and principal may be taxed as regular income. Interest is taxed as regular income. Principal is never taxed.

Annuity vs. CD: Which should you choose?

Because individuals usually use CDs for terms ranging from six months to 10 years, CDs are a strong option for those who are pursuing short- or medium-term savings goals. People making longer-term plans for retirement down the line, however, may want to do more research on investing in annuities. Because these investments give you the option to receive steady payments for a fixed amount of time, say 20 years or until you pass away, they can act as a good option for retirees who would like to receive regular income payments throughout their retirement. Annuities can act as a partial substitute for income once you’ve retired from the workforce.

Bottom line

When planning for your financial future, you’ll want to consider a variety of investment opportunities, including both annuities and CDs. Everybody’s financial situation and saving goals are unique. Are you looking to invest now to receive fixed payments over the course of 20 years once you’ve retired? Or are you hoping to earn some interest over the course of a year or five in a more secure fashion? Perhaps you’re looking to do a bit of both.

Most importantly, keep doing research. When evaluating your investment portfolio, think through the pros and cons of annuities and CDs, what they have to offer and how they fit into your long-term goals.

The post Annuity vs. CD: What’s the Difference? appeared first on MagnifyMoney.

Source: https://www.magnifymoney.com/blog/banking/annuity-vs-cd/

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