Annuities vs CDs

When people look for a savings alternative for the safe money, one of the first places they look is their bank for certificates of deposits (CDs), and, why not? They’re easy, convenient, and, they are safe. There may not be any argument from financial planners that, if you have a high priority savings goal with a time horizon of ten years or less, CDs are one of the better options. However, if your time horizon is further out, such as retirement, annuities may be a better alternative due to their tax advantages and rate guarantees. Even in the shorter term, annuities can offer some advantages when considered in the context of your overall financial situation.

Bank CD Basics

CDs are time deposits that provide a credited rate of interest on money held for a specified period of time. The credited rate is based on the prevailing interest rate market, typically tied to the rates available on short term Treasuries. CDs are issued with a maturity date which is the period of time your money must remain on deposit in order to receive the full credited rates. CD maturities range from three month to five years, and the credited rate of interest tends to be higher on CDs with longer maturities.

Also, credited rates increase with the size of the deposit. Jumbo CDs, for deposits of $100,000 or more receive higher rates of return than smaller deposits. The interest earned on all CDs is taxable as earned, and it can be paid out as income or left to accrue in the CD. Early withdrawals from CDs will result in an interest penalty that is usually a loss of interest earned for a specified period of time.

CDs are considered to be among the safest of investments because of the system of Federal Deposit Insurance Corporation (FDIC) that provides member banks with coverage on individual deposits up to $250,000 per account, per bank.

Annuity Basics

When comparing annuities and CDs, fixed annuities provide the closest comparison. They are a contract with a life insurance company that offers a long term accumulation account combined with a distribution component that will guarantee a monthly income for life or some specified period of time.

The accumulation account is credited with a fixed rate, and, like CDs the rates are guaranteed for varying lengths of time with higher rates credited for the longer durations. The durations are generally tied to a surrender period during which, if a withdrawal is made that exceeds 10% of the account value, will result in a fee. Each year, the fee is reduced by a percentage point so that it declines to zero to coincide with the end of the surrender period. It is usually at that point when the rate guarantee expires and a new rate is established.

Earnings in fixed annuities are allowed to accumulate tax deferred until they are withdrawn when they are then taxed as ordinary income. Withdrawals made prior to age 59 ½ may also be subject to an IRS penalty of 10%.

Annuities are also considered to be among the safest of investments since they are issued by life insurance companies which are, historically, among the strongest and most stable of all financial institutions. Although they are not covered by FDIC insurance, most states provide insurance coverage through state guarantee funds. These have yet to be used because life insurance companies, unlike banks, are required to carry reserve assets that are sufficient to pay all of their future obligations.

Which is Best for You?

Any consideration of annuities versus CDs as savings alternatives need s to be made based on the same requirements and parameters that individual have for their savings dollars. If the savings goal is a high priority with a long term horizon of more than fifteen years, then the comparison is worth exploring. Here is a quick list of comparative features between the two:

Credited Rates

Bank CDs

Usually tied to short term Treasury securities and sensitive to interest rate movements. Rates can be guaranteed for a period of time after which they are adjusted with no protection against falling rates.


Yields are generated from the investment returns of the life insurer general account and tend to be higher than CDs in the short and long term. Annuities include a minimum rate guarantee which provides protection against sharply declining interest rates.

Tax Deferred Accumulation

Bank CDs

CDs earnings are taxed as ordinary income as received.


Annuity earnings are not currently taxed.

Safety of Principal

Bank CDs

CDs are protected by FDIC insurance, but only up to $250,000 per account owner per bank. FDIC has no direct backing of the U.S. Treasury and its reserves are only a small fraction of what banks have in outstanding obligations.


Annuities are protected by state guaranty funds which are fully funded for up to $250,000 of coverage. Additionally, life insurers are required to maintain a high level of liquid reserves that can be used to pay future obligations.

Access to Funds

Bank CDs

CDs must be held to maturity in order to receive the full amount of interest credited. Early withdrawals can result in the loss of six months of interest.


Annuity accounts can be accessed at anytime without a fee as long as the amount of the withdrawal does not exceed 10% of the account. Withdrawals made prior to age 59 1/2 may also be subject to a 10% IRS penalty. After the surrender period expires funds may be accessed without charge.


Annuities and CDs offer savers the highest amount of safety of their principal. Any comparison beyond that can only be made if they considered in the context of a long term time horizon. For individuals who can benefit from tax savings, annuities may provide the edge as far as competitive rates are concerned. While they both have some restricted access to funds, annuities may offer a little more flexibility for savers who may need early access for an emergency.

Who Should Buy Annuities

Annuities are unique in that they offer a wide range of benefits for investors, however, like any investment; they may not be suitable for everyone. Along with the benefits come certain restrictions or limitations that, if not fully understood, could work against an individual’s circumstances. But, for the right people, and when used in the proper financial context, annuities can be an unparalleled in their ability to help people reach their financial goals.

The features and characteristics that go into making annuities work the way they do are best understood when applying them to the financial needs and objectives of individuals who are better positioned to benefit by them. While not an exhaustive analysis, this can provide prospective annuity owners with a way to classify their positions to determine if annuities might suitable for them:

Suitable Candidates for Annuities

People who are Risk Adverse

Some people prefer to put their money in vehicles that have no exposure to risk. While that really isn’t possible, people associate savings accounts, T-Bills, and bank CDs with safety of principal. There are many different types of risk, which, if not accounted for in your savings or investment strategy, could have a detrimental effect on your long term savings. But, as a long term savings vehicle, annuities provide many layers of protection for preserving principal. In addition to principal guarantees offered in many annuities, they also include minimum rate guarantees to protect against steep declines in interest rates.

People who don’t Like Taxes

Nobody likes to pay taxes, but for those investors in the higher tax brackets, annuities offer benefit of tax deferral on earnings that accumulate inside the contract. For someone in the 50% tax bracket (combined state and federal), that would mean that their earnings could grow 50% faster than an equivalent taxable vehicle. They will, however, have to pay taxes on their earnings when they are withdrawn, but assuming they are in a lower combined tax bracket at retirement, they will end up saving on the amount of taxes that would have otherwise paid.

People who want a Competitive Edge

Even risk adverse people like to get that extra edge of a half a percent or more interest credited to their accounts. The yields on annuities tend to be higher than those available on equivalent savings vehicles. Additionally, many annuity contracts will pay a bonus rate on initial deposits that exceed a certain amount. And, for CD-Type annuities, the rates go up even further when the deposits are committed to a minimum guarantee period (i.e. five to 10 years).

People who are Thinking Long Term

For investors who have done a good job of establishing other savings or investment accounts that are available for meeting short term or emergency needs, they can turn toward annuities for their longer term needs. In return for the guarantees, the tax deferral, the competitive interest rates, and the extra layer of protection that annuities provide, the annuity provider asks that you commit your funds for a minimum period of time.
To do that, they have established surrender periods during which, if any withdrawal of funds is made in excess of 10% of the account value, it will charge a fee. This should be of no concern for investors with a long term time horizon because, eventually (within seven to 12 years), the surrender period ends and the funds can be withdrawn without a fee. Additionally, after age 59 ½, investors don’t have to worry about the 10% IRS penalty assessed on early withdrawals.

People who don’t Like Surprises

Even risk tolerant investors, especially those who experienced the shellacking in the markets of a few years ago, would like to have some stability and predictability built into their retirement portfolios. Annuities, with their minimum rate guarantees and minimum income guarantees can accomplish that. When combined with other investments that fluctuate in value due to market swings, fixed annuities can level out the downside returns with their steady rates and predictable income streams.
Risk tolerant investors might want to also consider variable annuities for their potential to earn market returns. Aside from the tax advantages of deferring taxes, many variable annuities offer options that will protect their value against market declines. Although these options come at an additional cost, savvy investors might look at it as a small insurance premium.

People who worry about Outliving their Income

If you are one of these people, you are not alone. Nearly 80% of Baby Boomers lay awake at night wondering if their assets are sufficient to generate the income they need for their lifetimes. Most of them are victims of the “lost decade” of the stock market from 2001 to 2009. Others just fell into the rut of not saving enough. In either case, people are approaching retirement with greater fear and many of them are turning to annuities to insure their financial security.

Annuities are built as income generators, but, unique to them are the guarantee of a minimum level of income for as long as a person needs it. Life insurers are able to convert a lump sum of capital into an income stream that cannot be outlived. Because the investors have to give up control of their annuity deposit, it is recommended that they have other assets under their control that are available for income investing as well as for short term needs.


While annuities aren’t for everyone, this list may very well include some attributes that most people share. Still, the key is to thoroughly understand your own needs, objectives, priorities, time horizon and tolerance for risk before you consider any investment. If you find yourself falling within one or more of the classifications outlined here, annuities may be the right choice for you.

Understanding Deferred Annuities

The robust benefits of a deferred annuity account can occur whether you invest in a variable, fixed, or indexed annuity account. The taxes that are gained during the accumulation period is simply “deferred” or put off until the time you make your first withdrawal at a later date. This allows the investor to grow his account without receiving a 1099 for every tax year for that account’s growth.

Annuities are saving vehicles and contracts that are backed by insurance companies and which deliver a return on investment for those investors who purchase them. Annuities are often compared to CDs or Certificates of Deposits, which generate interest over a period specified time. Deferred annuities, unlike traditional CDs however, are saving instruments that are allowed to accumulate assets over time without being taxed on that income growth. Yet, if you withdrawal from your account before you turn 59.5 years of age, the standard penalty is about 10% is applied. Of course, that additional income also results in the paying taxes in your particular tax bracket at the time of the withdrawal.

Often, your “deferred” annuity account can changed to an “immediate” annuity after a particular period of time has passed – such change in the type of annuity is often written in the language of the contract. An immediate annuity will immediately deliver payments to the investor at a percentage he established for a particular period of time. Aside from particular tax savings, other options can be given with a deferred annuity such as the ability to include a designated beneficiary that would guarantee payment for your loved ones in case of death.

A variable deferred annuity is a unique investment opportunity as it allows you to invest particular percentages in a variety of mutual funds, which are often referred to as “sub-accounts,” and which vary in yield and risk. Your return on investment will ultimately depend on the performance of each of those “sub accounts” in your portfolio. A variable annuity also allows for the standard fixed-rate annuity and can provide another layer of stability for those adverse to higher levels of risk.

Depending on which kind of deferred annuity you have you, investors may have the flexibility to transfer money from one annuity investment to another, without being taxed. However, you may have to incur charges from the actual insurance company to transfer those funds. Nevertheless, this gives the investor a bit more flexibility in where to keep his or her money.

In addition, some deferred annuities allow you to skip paying taxed until only the time the money actually distributed back to the investor, in which case the investor would pay an income tax at their standard rate. Payments taken before retirement or before the age 59.5, investors will have to pay a penalty fee as you do with other similar annuities, which is usually 10%.

During the distribution period an investor can also choose to have their investment plus earnings given to you in one “lump sum” or you may choose to receive payment installments for a specific period of time. Payout payments can be determined for a specific period of time, such as 25 years, and can be paid out in a manner that is indicative of their market performance. You will be taxed for the payments you receive on the interest that you earned. For example, if an investor contributed $100,000 and earned $50,000 for a total of $150,000, he or she would only have to pay taxes on that $50,000.

How Annuities are Taxed

As a tax-deferred vehicle under the Internal Revenue Code, annuities as a family of investments are attractive to investors as they allow you to accumulate assets and pay no taxes on the gains of those investments until you actually make a withdrawal on that account. An annuity is a financial contract that promises to make payments to the investor, for a specific period of time, and is often sold or backed by an insurance company.

Since, annuities allow the investor’s money to increase without being taxed every year for the growth in the investment, such contracts act like certificate of deposits that guarantee a predictable rate of return over a particular time – without having to take out a 1099 every year. The question of taxation generally depends on the type of annuity it is and how you purchased it. Because payments for annuity accounts are often made during the accumulation phase in after tax dollars, the investor pays no taxes on the principal investment, but only the earnings.

On the other hand, if you purchase your annuity with money in your IRA with pre-tax funds, then all of the money you get during the distribution phase will be taxed at full rate as those earnings have never been taxed. Another feature that may offer flexibility to the investor is that annuities allow you to transfer money from one variable annuity investment to another, without being taxed or penalized. Only, at the time the money withdrawn from your account is when you actually pay an income tax at your standard tax rate, and not the capital gains rate. If you have money distributed to you before your retirement or before you turn 59.5 years of age, you will also have to pay a standard penalty fee of 10%.

The calculation for annual taxation depends on how the investor withdraws his funds. For illustration purposes, let’s say the investor elects to withdraw all of his money in one lump sum, and the payments he made were purchased with “after tax” dollars. If he invested $10,000 and the account is now with $16,000 – the investor will only pay taxes on the $6000 or the gain in the value the annuity. He keeps the original $10,000 and skips double-taxation. However, if the investor made in his annuity purchase payments with pre-tax dollars, then he will have to pay taxes on the entire $16,000. This may happen when an investor purchases an IRA with pre-tax funds and then elects to purchase annuities with those funds or extra funds. Keep in mind, however, that if an investor withdraws a lump sum payment from his account of say, $500,000, he would be subject to a different tax bracket for that year.

Further, if the investor decides to “annuitize” payments from the annuity account, he will be subject to paying taxes on the earnings of his investment based on his yearly tax bracket – which would be different if he took a significant one lump sum payment. A bit more complex then the lump sum payout, the amount of money taken out in an annuitized manner is taxed by calculated by generating an “exclusion ratio.” This exclusion ratio is figured out by taking the amount of the investment, and dividing it by the amount that is expected to be earned during the distribution period – say monthly or per year.

In addition, if you have a variable annuity, these accounts may be taxed a bit differently since the market changes from month to month, but the calculation is also determined to figure out the exclusion ratio. To ensure proper taxation with regards to your specific taxation scenario you should consult your tax preparer.


Annuities and Risk

Annuities are contracts purchased by an investor from an insurance company in exchange for payment on a specific date, over a specific period of time, and usually at specific rate of return. With any financial investment a certain amount of risk is expected with annuities as with other investments. The risk of annuities depends on the type of the annuity chosen by the investor and also includes the long term stability and health of the insurance company the investor is making the purchase from.

It is important to note that annuities are not backed up by the FDIC and some may not be registered with the SEC. However, certain states may have special annuity coverage funds if the company issuing the annuity goes under through “guarantee associations.” The amount of coverage varies depending on which state you live in. For example the state of Washington seems has the highest protection of $500,000. If the insurance company which the annuity was purchased from is not able to cover their obligations, usually other insurance companies step in and buy out the company and redeem some of the investments. This practice preserves the health of the entire industry.

A fixed annuity is a contract that determines a specific rate of return over a particular period of time. The level of risk may be considered lower than other annuities because its health is not necessarily based on market fluctuations, but rather more stable insurance pools. The drawback for some investors is that the Rate of Return for fixed annuities is not as dramatic as other investments. A variable annuity on the other hand, allows the investor the ability to determine the level of risk. By allowing the investor to determine the percentage of his payments into subgroups, the risk can either increase or decrease. For example, if you decided to purchase a variable annuity and place 75% of your payments into a higher risk mutual fund and the rest into a lower risk fund, the overall risk of that annuity may increase. The level of return would ultimately depend on the performance level for each of those funds chosen as a percentage of your portfolio. Variable annuities also allow you to invest a percentage of the funds into a fixed mutual fund as one would in a traditional fixed annuity account. This provides an increase level of freedom for the investor to diversify his portfolio.

Index annuities are based entirely on the performance of the equity market. The level of return would primarily be based on whether the market goes up or down and would inherently have a bit more risk than a fixed-deferred annuity or a variable annuity. As other annuities, index annuities can provide good long term investments if we consider the historical levels of market performances that trend upward through the years.

In addition, savvy investors find annuities as often attractive investments because they can weather through significant market volatility, falling interest rates, and deferred tax obligations based on any earnings due to interest over time. The best way to understand the risk associated with each annuity is to thoroughly read the prospectus and investigation the rating of the issuing company.