We answer some of the most common questions we get from potential clients regarding CDs and fixed annuities.
- Fixed annuities can offer higher rates than CDs due to the longer-term investment periods, and subsequently, the insurers’ ability to invest in long-term, less liquid investment strategies.
- As retirement products, fixed annuities offer tax deferral of interest income but cannot be accessed without penalty before age 59½
- Fixed annuities are not FDIC insured but are guaranteed by the claims paying ability of the insurer.
The rates that banks are paying on CDs have come down significantly as the Federal Reserve has lowered the Fed Funds Rate over the last year by more than 2%. We have seen many people with maturing CDs taking a close look at fixed annuities for the first time because the top rates on fixed annuities are generally significantly higher than CDs.
In this post, I’ll discuss some of the most common questions we receive about the similarities and differences between bank-issued CDs and insurer-issued fixed annuities.
When I say fixed annuities, I’m referring to multi-year guaranteed annuities — products that pay a fixed, guaranteed rate of return for a set number of years with penalty-free access to the funds at the end of the term. I am not referring to indexed annuities or other products that do not pay a guaranteed return.
With that in mind, let’s dig in. Below, I’ve answered the questions we hear most often from prospective clients about the differences between the two products.
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1 – How is my money guaranteed if insurance companies are not backed by the FDIC like CDs?
Certificates of Deposit (CDs) come with protection insurance up to the applicable limits by the Federal Deposit Insurance Corporation (FDIC), assuming the issuer is a member bank.
Fixed annuity guarantees, on the other hand, are subject to the claims-paying ability of the insurer. An insurer’s financial strength ratings, assigned by a third-party rating agency, are a good shorthand measure of financial strength.
There are four major rating agencies in the U.S. that rate insurance companies — AM Best, Fitch, Moody’s and Standard & Poor’s. All insurers on the Blueprint Income platform have at least a B+ rating from AM Best.
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Annuities are not FDIC insured and are not bank deposits. Although each state does have its own guaranty fund, it should not be thought of as a substitute for FDIC insurance. State guaranty fund rules vary significantly state-by-state. You can find more state specific information here.
2 – My bank doesn’t charge a fee to open a CD. What fees are associated with purchasing a fixed annuity?
There are no direct or ongoing fees for a fixed annuity. We do receive a commission for fixed annuity purchases on our platform that averages about 2%. This is already reflected in the rates you see on the website and is not a direct cost to you. For example, if you put $100,000 into a fixed annuity offering 3.0%, you’ll earn exactly 3.0% on the full $100,000. The rate you see on our website is the one you will get – no additions or subtractions.
3 – How can insurance companies offer higher interest rates than banks?
Typically, fixed annuities are longer-term investments than CDs. This longer time horizon provides insurers more flexibility in their investment strategy. Longer-term and more illiquid investment strategies can lead to higher investment returns. There are also important differences in regulatory regimes that can result in different cost structures, risk tolerances, and investment strategies. In general, states are the primary insurance regulators, and the federal government (via the Fed and Office of the Comptroller of the Currency) is the primary bank regulator.
4 – CDs carry withdrawal penalties, but what happens if I need to take money out of my annuity?
Some fixed annuities (generally those paying the highest rate) do not allow for any withdrawals prior to the end of the investment term without incurring a surrender charge. Surrender charges vary, but can be as high as 9% in year 1 and typically decline by 1% per year. Other fixed annuities allow for penalty-free withdrawals of interest earned. However, this is sometimes restricted in the first year. Still other fixed annuities allow for annual withdrawals of up to 10% of that year’s account balance.
Although in recent years, there has been the advent of a limited number of penalty-free CDs, these are rare and generally pay less interest than their penalty-free counterparts. For the vast majority of CDs, there are penalties for early withdrawals that are levied in the form of forgoing a certain number of months worth of interest in exchange. The longer the CD term, the higher the early withdrawal penalty. You can find a fairly comprehensive list of the major banks and their penalty rates here, along with a withdrawal penalty calculator.
5 – I heard annuities were retirement products only. What happens if I want to withdraw my money before I retire?
You’re correct – annuities are considered retirement products by the IRS. You’re given the advantage of tax deferral of interest earned, but that comes with a price. If you’re under the age of 59.5 and take a withdrawal (even if it’s allowed in the annuity contract), you will have to pay a 10% penalty on the interest earned to the IRS.
6 – How is a fixed annuity taxed differently than a CD?
Both CDs and fixed annuities earn a set interest rate each year. The IRS, however, treats interest on CDs as income in the year it is earned. Annuities, on the other hand, benefit from tax-deferred growth, meaning you’re not taxed until the funds are withdrawn from the annuity. Not only does this provide more flexibility in your year-by-year tax planning compared with a CD, it also allows for more interest to be earned through compounding.
7 – I typically buy 18 month or 2 year CDs. Can I buy an annuity with a similar term length?
Insurance companies typically offer fixed annuities with investment terms of 3 years or more. The longer investment term allows them to invest your money for longer and pay higher rates in return. We are seeing some insurance companies release 2 year fixed annuities, but the most common products come with 3, 5, 7, or 10 year terms. Banks, generally, offer CDs with terms topping out at 2 years with a select few offering 3 and 5 year terms.
8 – What happens at the end of the guaranteed term in an annuity?
With both annuities and CDs, it can vary greatly, so be sure to to read the fine print. Let’s look at annuities in more detail. If you purchased your fixed annuity through Blueprint Income, we will alert you as your annuity gets close to the end of its guaranteed term. You have four options when the term expires:
- You can take funds as a lump sum
- You can transfer the funds into a new annuity via a 1035 exchange
- You can annuitize the funds (i.e. purchase an immediate annuity)
- You can do nothing and leave the funds in the same contract
If you decide to simply take the funds and keep them in cash, the interest earned over the life of the investment will be taxed as ordinary income. Additionally, if you take the full payment from the annuity and you are under 59.5, you will incur that 10% penalty from the IRS.
If you use a 1035 exchange into another annuity, you can maintain the tax deferral. There is no limit to how many times you can do a 1035 exchange (with the caveat that many insurers do not offer fixed annuities with issue ages beyond 90). Your taxes would be deferred from exchange to exchange, and you would pay taxes on the interest you earned over the multiple annuity terms (original and any subsequent 1035 exchanges) once you eventually withdraw money. For example, if you had a $100,000 policy that earned $9,000 in interest over a 3 year term that you roll into another 3 year annuity with a 1035 exchange that earns $12,000, you would owe taxes on the full $21,000 if you were to take a lump sum payment at the end of the 6 years.
If instead you decide to annuitize the money, you will then have a lifetime stream of monthly income, which will only be taxed according to the amount of each payment the IRS determines to be profit (a concept called the exclusion ratio – a subject covered in depth here).
If you do nothing, your funds will remain in the same contract. Either the money will earn a “renewal” rate that’s set annually, or you may be automatically renewed by the insurer into a product of the same term. Make sure to read the contract details carefully and stay on top of renewals.
9 – How does the application process differ between CDs and fixed annuities?
Using our digital application, it takes about 10 minutes to complete the application for a fixed annuity. Some financial information we collect is intended to make sure the annuity is suitable for you and matches your objectives. The first application may be slightly more onerous than buying a CD at your local bank, but subsequent purchases are easy so long as the information you provided for the original application has remained intact.
Although there are others, these are some of the major differences between CDs and fixed annuities. If you’d like to read more on fixed annuities, we have a full guide on the product. Ready to see rates? View our fixed annuity rates and tailor your search to your state and the premium you’re looking to contribute.
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