One of the most oversold and underperforming financial vehicles in America is the Certificate of Deposit or commonly called the CD. The CD has become a popular investment tool for many American’s due to its slightly higher rates than many bank savings accounts. In addition, many older Americans put their savings into CD’s because they are FDIC insured as long as the bank is a member of FDIC.
The Pros and Cons of CDs
Proponents of CDs claim that their benefits include:
- A higher rate of return than a savings account
- The rate is locked in and will not drop due to market fluctuations
- Impulse spenders will not have easy access to the funds and therefore will not be tempted to overspend
However, there are several disadvantages to tying up money in a CD that include:
- A very low rate of return compared to other relatively safe investments
- Funds cannot be taken out until the CD matures
- A locked in rate that may be lower than current interest rates
- If the funds are removed before maturity, the interest is docked which could result in losing some of the principal
The Inflation Argument
With the numerous negative aspects of investing in CDs, inflation might be at the top of the list. In the last 100 years, the annual rate of inflation has been 3.22%. This means that if a CD pays less than 3% interest yearly, a person who purchases a CD is actually losing money. Since there hasn’t been a year with a negative inflation rate since 1939, chances are that if a person purchases a CD, it will not keep up with the annual inflation rate.
In addition, a CD has taxed annually which means that the government is paid for the interest earned on the CD even though a person doesn’t have access to the funds. The taxes must be paid, so this means that current liquid funds must be used to pay Uncle Sam.
For example, a person who purchases a $100,000 CD will earn $1850 in interest income for the year based on current CD rates. For a person in the 28% tax bracket will owe over $500 on this yield and have to pay this amount from other funds since the CD returns are locked up for the length of the CD.
To add insult to injury, with the annual inflation rate of 3.22%, that same $100,000 also loses $3220 in spending power. This means that after paying taxes and a loss of spending power due to inflation, the money invested into “safe” CD just saw a negative gain of $1888!
Fixed Annuities Are Better than CDs
Fixed annuities are similar to bank CDS in that they both pay a predictable stream of income without the risk of loss on principal. Both offer various investment time frames and low or no fees or expenses to eat into the initial investment.
However, the key differences between the two usually lead informed investors to choose fixed annuities.
- Principal Guarantees—Insured by the FDIC up to a quarter of a million dollars, CD proponents claim that CDs are a safe investment. Fixed annuities are not insured by FDIC, but they are backed by solid insurance companies, some which have been around longer than the FDIC. In addition, many states have guaranty funds to repay annuity holders in the event of a company collapse.
- Tax Treatment—Taxes on gains from a CD must be paid annually even though the gains are not available until the CD maturity date. Fixed annuities are tax-deferred which means that taxes on the gains are not due until the funds are withdrawn from the annuity.
- Renewal Provisions—When a CD matures, the option for renewal is available, but only at the current interest rate. If the interest rate has fallen, there are not many options left for CD holders. Fixed annuities can be structured so that when the period ends, the annuity stays in existence and pays a new interest rate that has been predetermined according to the contract.
- Penalties—Banks often charge heavy penalties for early withdrawals on CDs. Fixed annuities can contain provisions to allow for withdrawal of some of the principal without penalty.
- Distribution Options—There are limited options for withdrawal of funds with a CD. Basically, a person is limited to waiting until the CD matures to access funds. However, with fixed annuities, there are many different options for access to funds. Often, there is free access to specified amounts of money after a particular period of time. One of the huge advantages of a fixed annuity is that it can generally be changed into an annuitized contract which gives the owner the ability to lock in fixed monthly payments for life.
- Exemptions—CDs are considered “non-exempt” when involved in lawsuits. If an annuity owner falls into financial distress or is involved in a lawsuit, their CD is fair game to creditor confiscation. In some states, annuities are exempt from this law and therefore safe from lawsuits or creditors.
- Probate—When a person passes, before heirs can gain access to a CD, it must go through the probate process which can be lengthy and complicated. Annuities are structured to have a designated beneficiary and bypass the probate process.
- Deposits—For a retiree or potential retiree to purchase CDs in excess of $250,000, they must own various bank accounts in order to deposit the excess. The FDIC only insures amounts up to $250,000, but insurance companies guarantee and insure annuities that are not restricted to limits. Experts advise that before investing large sums in any company, research the financial security of the issuing entity.
In addition to the numerous key differences between fixed annuities and CDs, a fixed CD can be crafted to include joint and survivor options that allow a spouse to receive payments after the passing of the annuity holder. With the many different advantages of annuities over CDs, talking with a financial expert to decide how to structure retirement funds can mean the difference between gain and loss of retirement income.