Choosing between a CD or an annuity can be challenging. Both offer secure, low-risk ways to grow your money, but they work differently. Wondering which is the better option for you? This guide will help compare CDs and annuities to make your decision easier.
What is a CD?
A Certificate of deposit (CD) is a savings account you can open at a bank or credit union.
Here’s how it works:
- You deposit money for a set period.
- You earn interest during that time.
- The fixed interest rate won’t change throughout the term.
- Common terms range from a few months to several years.
One of the main benefits is that CDs have insurance from the Federal Deposit Insurance Corporation (FDIC), up to $250,000 for each person per bank. This protection means your money is safe, even if the bank fails. If you have a CD with a credit union, then it has National Credit Union Administration (NCUA) protection.
What is an Annuity?
An annuity is a type of contract you purchase from an insurance company for guaranteed income.
Here’s how it works:
- You invest a lump sum or make payments over time.
- The insurance company promises to pay you regular income, either right away (immediate) or in the future (deferred).
There are different types of annuities, such as variable, fixed-index, and fixed. However, the fixed annuity is the most similar to a CD.
A fixed annuity guarantees a set interest rate for a specific period. However, the money in an annuity grows tax-deferred until you start withdrawing it. This can make it a good option for long-term savings, especially for retirement.
4 Key Differences Between a CD and an Annuity
Let’s break down the main features you should focus on when choosing a CD or an annuity.
1. Liquidity
CDs and fixed annuities have set terms, but CDs typically range from a few months to several years. They both have early withdrawals trigger penalties. Fixed annuities, not CD investments, lock in your money for longer periods. This comes with high surrender charges and fees if you withdraw early.
2. Tax Treatment
CDs, unlike fixed annuities, are taxed annually on the interest earned. This could take a chunk out of the growth. Fixed annuities allow your earnings to grow tax-deferred. This deferral means you don’t pay taxes until you start withdrawing.
Remember that deferral doesn’t mean avoiding taxes—you will face taxes eventually.
3. Interest Rates
If you compare a CD to a fixed annuity, a CD usually offers lower but guaranteed interest rates. A fixed annuity tends to offer higher guaranteed rates. A higher rate makes them more appealing for long-term growth.
4. Financial Risk
CDs are FDIC-insured, so your money is protected up to $250,000 for each account. If your CD is backed by a credit union, it has NCUA protection. Annuities rely on the financial strength of the insurance company, so without FDIC protection, you won’t have protection if a bank collapses.
Fixed Annuity vs CD: Pros and Cons
You must examine the advantages and disadvantages when deciding which is better, a CD or an annuity. If you need help deciding between a CD or fixed annuity, consult a financial advisor to analyze your position.
Advantages of a CD
These are the advantages of choosing a CD vs an annuity:
- Simple to understand.
- FDIC-insured or covered by NCUA, so your money is protected.
- Shorter commitment periods, often a few months to a few years—more liquidity than an annuity.
- Guaranteed fixed interest rates.
Disadvantages of a CD
These are the disadvantages of choosing a CD vs an annuity:
- Lower interest rates compared to other investments.
- Early withdrawals come with penalties.
- Risk of losing purchasing power because of inflation.
- Potential tax burden for the accrued interest.
Advantages of an Annuity
These are the advantages of choosing an annuity vs a CD:
- Higher potential interest rates than CDs.
- Offers tax-deferred growth, which can boost savings over time.
- Can provide a steady income stream, especially useful for retirement.
Disadvantages of an Annuity
These are the disadvantages of choosing an annuity vs a CD:
- Longer commitment, often requiring several years or even decades.
- Not FDIC-insured, relying on the financial stability of the issuing insurance company.
- Early withdrawals may result in surrender charges or penalties.
When to Choose a CD vs an Annuity
A CD is a good choice if you have short-term financial goals. It’s ideal if you want a safe place to park your money for months or years. CDs work well for those who prefer lower risk and guaranteed returns.
CDs are also great if you value FDIC protection, ensuring your money is secure up to $250,000 per account. If you need access to your money within a shorter time frame or want a straightforward option, a CD might be the best option for you.
Let’s say you’re nearing retirement and you’re undecided about an annuity or CD investment. You might want to protect part of your savings from stock market swings. You can place some funds in a 5-year CD because it offers a guaranteed return, and you won’t lose your principal. An annuity will tie up her money for too long or deal with more complicated rules and fees.
When to Choose a Fixed Annuity vs a CD
A fixed annuity is a better choice if you’re planning for the long term, especially for retirement. It offers higher interest rates than a CD, allowing your money to grow tax-deferred. This means you won’t pay taxes on the earnings until you start withdrawing.
If you’re looking for a reliable income stream in retirement, a fixed annuity can provide that. It’s ideal for those who don’t need immediate access to funds and are comfortable with a longer commitment. Make sure you’re secure with the insurance company’s strength.
You might choose this if you want to keep saving for retirement in a tax-advantaged way. This may be an option if you maxed out your 401k and IRA contributions. You can buy a fixed annuity because your savings grow tax-deferred until you withdraw.
You won’t pay taxes on the growth each year. A CD wouldn’t work either because you’d have to pay taxes on the interest earned yearly, limiting growth.
Which is Better—CD or Annuity?
The choice between a CD or a fixed annuity depends on your financial goals and how long you want to invest. Work with our expert team at Asset Preservation to help you find the best solution for your needs.
Work with a trusted team today!
Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not refer in any way to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims paying ability of the issuing company; not guaranteed by any bank or the FDIC.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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