The annuity market is a corner of the investing world in which many people fear to tread, but in many cases, annuity products can be a suitable option to meet your investing goals. The key, though, is to understand what annuities really are and how they differ from investments with which you're more familiar. Today, we'll take a look at the fixed annuity, which is often marketed as an alternative to a bank certificate of deposit. Below, you'll find several ways in which fixed annuities differ from bank CDs.
The similarities between bank CDs and fixed annuities
Fixed annuities have a lot in common with bank CDs. They're both designed to pay predictable streams of income to investors without taking the risk of losing principal. Both offer a range of time frames over which you can invest, and for the most part, both allow for all of your money to get invested without any sales fees or other expenses eating directly into your initial investment.
But there are still some key differences that you should know about before you choose between a fixed annuity and a bank CD. In particular:
1. Principal guarantees
Bank CDs are insured by the FDIC up to $250,000 per person at each bank. In the event of a bank failure, the FDIC will make you whole against any losses up to that amount. Fixed annuities don't get FDIC insurance, but they're backed by the insurance company that issues them. Moreover, in many states, guaranty funds exist to help repay some or all of any losses that annuity holders suffer if the issuing insurance company fails.
2. Tax treatment
Bank CDs are taxable accounts unless you hold them in a retirement account like an IRA. By contrast, fixed annuities generate income on a tax-deferred basis, and you don't have to pay taxes on the gains within the annuity until you withdraw them.
There's a trade-off for this tax treatment, though. Withdrawals from annuities can be subject to the same 10% early withdrawal penalty that applies to retirement accounts if they're made before age 59 1/2. As a result, many advisors recommend fixed annuities for those who are in or near retirement.
3. Renewal provisions
At the end of the term of a CD, you have the option to renew the CD for another period. However, the rate of interest you'll earn will change, with the potential either to rise or fall depending on what has happened to prevailing rates in the interim.
Fixed annuities also have guaranteed periods, but when those periods end, the annuity stays in existence, paying a new rate that's determined according to the annuity contract. As with CDs, the rate can be higher or lower than the initial guaranteed rate. However, some fixed annuities contain guarantees that say the rate will never fall below a certain amount, which can add some extra incomeif CD rates hit rock-bottom levels.
4. Penalties for early access to your money
Bank CDs charge penalties for early withdrawal that usually vary with the length of the CD. Short-term CDs can impose penalties of as little as a week's worth of interest, while longer-term CDs sometimes will include early withdrawal penalties of a year of interest or more.
Fixed annuities often include provisions that allow you access to at least some of your principal without penalty. However, it's important to look at the annuity provisions governing withdrawals, as large surrender charges can apply if you haven't owned your annuity long enough and try to take out more money than the contract allows.
5. Options for receiving distributions
With a CD, you have limited choices for getting money out of your account. In general, you have a short period when the CD matures to take money out of the CD or add new money to the account. Otherwise, the CD will generally automatically renew for another period of the same length. Withdrawals at other times are generally subject to the early withdrawal penalties discussed above.
Fixed annuities, however, come with many different choices. You can generally get free access to your money in the amounts you specify after a certain set period of time, with different contracts setting different limitations on withdrawals. The big advantage of a fixed annuity is that you can generally annuitize the contract at any time, giving you the ability to lock in fixed monthly payments for the rest of your life. Joint and survivor options can also let you and a loved one receive payments as long as at least one of you lives. In addition, certain guarantees of minimum income or death benefits can also have an impact on your best strategy for taking money out of a fixed annuity.
Fixed annuities have features that differ from bank CDs, so it's important not to think of them as interchangeable. Some will favor annuities and others CDs, but you'll need to figure out which features you find most valuable to decide whether a bank CD or a fixed annuity is right for you.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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