Turned off by Low CD Rates? Consider a Fixed Annuity

Rates on bank certificates of deposit are dismal. The best you can do as of early November 2020 is a mere 0.65% for a one-year CD, 0.85% for a three-year CD, and 1.00% for a five-year certificate, according to Bankrate.com.

While you’re certain to get your money back, because CDs are insured by the FDIC, you’re also virtually certain to lose money after inflation and taxes.

There’s a better way to save money for many people.  It’s a fixed-rate annuity — also known as a multi-year guarantee annuity or a CD-type annuity. You can earn up to 2.40% for a three-year fixed annuity and up to 3.05% annually for a five-year contract, according to AnnuityAdvantage’s large database of annuity rates.

Like a CD, a fixed annuity pays a guaranteed interest rate for a set period, usually three to 10 years.  There’s no sales charge, so all of your money goes to work for you immediately. The interest is tax-deferred.

While annuities are not FDIC-insured, they are covered by state guaranty associations, up to certain limits, which vary by state.  While this is a valuable backstop, the odds that you’ll ever need to rely on the guaranty association are very small. Annuities are issued and guaranteed by life insurance companies, which are strictly regulated by the states to ensure their solvency. This system has worked well. 

Besides higher rates, here are the additional ways fixed-rate annuities beat CDs.

Tax-deferral. All CD interest is subject to federal and state income tax annually, even when it’s reinvested and compounded in the CD (unless the CD is in an IRA or other retirement account).

A fixed annuity, on the other hand, is tax-deferred. You won’t receive an annual 1099 and you won’t pay tax on the interest until you withdraw it. At the end of the annuity’s initial guarantee period, you may renew it for another term or roll it over into another annuity.

Tax deferral isn’t an advantage when you hold an annuity in an IRA or other retirement account. However, since you get a guaranteed, competitive rate, a fixed annuity is still a top choice for the portion of your retirement-plan assets you want to shelter from stock-market risk while earning an attractive rate of interest.

For certain retirees, lower taxes on Social Security benefits. About 40% of retirees who receive Social Security pay taxes on at least a portion of their benefits. By moving some of your money from a CD into an annuity, you’ll reduce income that may trigger the tax on Social Security benefits.

Most people who are taxed on their Social Security benefits will profit from this strategy, but not high-income retirees who are well past the threshold. Consult the Social Security website (www.ssa.gov/benefits/retirement/planner/taxes.html) to see how you may be taxed and whether this strategy may work for you.

Greater unpenalized liquidity.  Banks impose substantial penalties on all early withdrawals from CDs. Most fixed-rate annuities let you withdraw interest or up to 10% of the value annually without penalty. You will owe income taxes on any interest withdrawn.

Continuing tax deferral and flexibility. Once the fixed term is up, you may renew or can roll over the proceeds into a new annuity of any type and continue to postpone taxes. When you get closer to retirement, you may decide to annuitize the contract. That means you would convert the fixed annuity into an income annuity.  You will get a guaranteed lifetime monthly income that begins either immediately or at a future date you select.

One disadvantage vs. CDs. If you withdraw money from your annuity before age 59½, you’ll owe the IRS a 10% penalty on the interest earnings you’ve withdrawn, plus regular income tax on it, as you would at any age. If you’re sure you won’t need the money in the annuity before that age, you’re good to go. If not, it might be wiser to delay purchasing one until you’re older.

This caution doesn’t apply to a fixed annuity in an IRA since you normally won’t take money out of an IRA until you’re past 59½ anyway.