CDs vs. Annuities: An Overview
Certificates of deposit (CDs) and annuities can both be good ways to save for the future. Both types of investment offer a low-risk, low-return way of investing. However, there are some important differences between these financial products.
The most important is the length of time that each type of investment is designed for. Most people will use an annuity to save for retirement—that is, as a long-term investment. In contrast, CDs are best used for short- to medium-term investments. If you are looking to put aside some extra money for retirement, an annuity can be a good option. If you’ll need that money in five years, it’s better to go for a CD.
Key Takeaways
- Both CDs and annuities are very safe investments. Both offer a set return on your money and are insured or guaranteed by the FDIC or insurers.
- CDs can be more flexible than annuities, with shorter terms and lower penalties if you need to withdraw your money in an emergency.
- Annuities will generally pay a higher interest rate than CDs.
- The most fundamental difference between a CD and an annuity relates to the amount of time they are designed to be held for—a CD is best for short- to medium-term investments and an annuity is usually a long-term investment for retirement.
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Certificates of Deposit
Risk
CD investments are protected by the same insurance that covers all deposit products. The Federal Deposit Insurance Corporation (FDIC) provides insurance for bank customers, and the National Credit Union Administration (NCUA) provides insurance for credit union customers. When you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 (per account, per account category) of your funds on deposit with that institution are protected if that institution were to fail.
Liquidity
CDs are not one of the most liquid investments, but they are more liquid than annuities. This is because you're required to lock your funds into an account for a set period. If you need to get to these funds in an emergency, you'll be asked to pay penalties because banks use the money you give them (you're essentially loaning them money in a CD). Withdrawing it early causes the bank to scramble for funds to replace what you've withdrawn, so the penalties help it make up some of the losses caused.
Interest rates
CD interest rates are generally lower than annuity rates but higher than those of savings accounts. This makes them an excellent way to preserve your capital, especially if their rates keep up or exceed the inflation rate. Because inflation chips away at value, it's important to ensure your CDs have a rate that will make them at least keep up with inflation—which savings account rates generally don't do.
Taxes
The interest you earn through a CD is taxed as ordinary income—it is supposed to be reported as income on your annual tax filing. CDs can be less tax-efficient than annuities in some circ*mstances, but for most people, the other differences between these investment instruments will be more important than the tax implications of each.
Make sure you understand the early withdrawal penalties that apply to your annuity or CD account. If you need to access your money in an emergency, you might pay hefty fees. These fees are generally higher for an annuity because annuities are designed to be held for longer than a CD.
Annuities
Risk
Annuities aren’t insured by the FDIC or NCUA. However, they are generally insured by the issuing insurance company and, in most cases, by state guaranty associations. However, it’s important to ensure your annuity is issued by a highly-rated insurance company to make this protection as strong as possible.
Liquidity
Both CDs and annuities have early withdrawal penalties—that is, both are fairly inflexible investment vehicles because you must leave your money in them for a specified term. However, because annuities are generally designed to be held longer than CDs (until retirement, rather than just a few years), annuities can have higher penalties than CDs if you need to get your money back in an emergency.
Because of this, investors who are considering purchasing an annuity should carefully consider their financial requirements. Annuities usually have a surrender period, during which you cannot make withdrawals without paying a surrender charge or fee. There are also tax implications for withdrawals from retirement annuities before age 59½.
Interest rates
Though annuities are less flexible than CDs, this disadvantage is offset by an advantage—annuities generally pay a higher interest rate than CDs. This is because the financial institution you hold your annuity with is exposed to less risk due to the longer length of time you will hold it.
Depending on prevailing interest rates, a difference of just 1% or 2% can affect the long-term return on your investments. This can make an annuity a good option for older investors who are unlikely to need the liquidity offered by a CD and want to keep their investments low risk while earning a reasonable return.
Taxes
Annuities are designed for retirement and come with tax advantages when used in this way. The interest your annuity earns is tax-deferred, so you pay taxes only when you begin withdrawing from it. Withdrawals are taxed at the same tax rate as your ordinary income. If you fund an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan, you may also be entitled to a tax deduction for your contribution. This is known as a qualified annuity.
Special Considerations
There are several types of annuities, but they are mainly used for retirement purposes—to help individuals address the risk of outliving their savings. An annuity generally pays you an income stream over time. This makes an annuity suitable for people looking to secure a steady income stream in retirement.
CDs come with different maturities and pay you a lump sum when they mature. So, CDs are more suited to those looking to save money for a short-term goal. However, you can use CDs to design income streams using a CD ladder approach. Rather than rolling them into another CD, you can use the proceeds as income as they mature and payout.
Is an Annuity Better Than a CD?
It depends. If you want to save in the short term, a CD can offer more flexibility than an annuity. An annuity is a better choice if you want to ensure a steady income stream in retirement.
Are CDs and Annuities Safe?
Yes. Both types of investment are insured—CDs by the FDIC or NCUA and annuities by the issuing insurance company. In most cases, state guaranty associations also add protection. It’s important to choose a financial institution you trust, but your money should be safe in either type of investment.
What Are Early Withdrawal Penalties?
Both CDs and annuities have fees and penalties if you withdraw your money early. You have to leave your money in the CD for the term you’ve agreed to, or you’ll probably have to pay sizable early withdrawal penalties that could wipe out your returns. Similarly, annuities have a surrender period, during which withdrawals will incur a deferred sales fee. This period generally spans several years.
The Bottom Line
Both CDs and annuities are very safe investments. Both offer a set return on your money and are guaranteed or insured.
There are differences, however. CDs can be more flexible than annuities, with shorter terms and lower penalties if you need to withdraw your money in an emergency. Annuities will generally pay a higher interest rate than CDs. A CD is best for short- to medium-term investments and an annuity is better for a long-term investment in your retirement.
