What Is a CD Type Annuity & How Does It Work?
Unpack the mechanics of a CD type annuity to understand its role as a unique financial instrument for your financial goals.
A CD type annuity is a financial product that blends characteristics of a traditional bank Certificate of Deposit (CD) with those of an annuity contract. This type of annuity, often referred to as a Multi-Year Guarantee Annuity (MYGA), offers a guaranteed fixed interest rate for a specific period. It functions as a deferred annuity, meaning earnings accumulate over time before withdrawals or income payments begin.
Understanding CD Type Annuities
A CD type annuity is a contract established with an insurance company, distinguishing it from bank-issued Certificates of Deposit. Its core mechanism involves an initial premium payment that grows at a guaranteed fixed interest rate over a predetermined term, typically ranging from 3 to 10 years. This structure provides predictability, similar to a bank CD.
The product operates in two main phases: accumulation and payout. During the accumulation phase, the invested principal and earned interest grow tax-deferred, compounding over the contract’s term. CD type annuities are primarily utilized for their accumulation potential and guaranteed growth.
Distinctive Features of CD Type Annuities
CD type annuities offer a guaranteed interest rate that remains fixed for the entire contract term, providing a predictable return on the initial investment. This rate is contractually guaranteed by the issuing insurance company.
Surrender charges are fees applied if funds are withdrawn before the end of the surrender charge period. This period typically aligns with the guaranteed interest rate term, and charges often decline over the years. Many contracts allow for limited liquidity, such as penalty-free withdrawals of a certain percentage, often 10% of the account value, per year.
CD type annuities typically include a death benefit, ensuring that beneficiaries receive the contract’s value upon the annuitant’s death, often bypassing the probate process.
CD Type Annuities Compared to Certificates of Deposit
While CD type annuities share similarities with traditional Certificates of Deposit, fundamental differences exist. CD type annuities are contracts with insurance companies; CDs are offered by banks.
Annuities are regulated by state insurance departments, and backed by the financial strength of the issuing insurance company and state guaranty associations, though coverage limits vary by state. CDs are governed by banking regulations and are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor.
Their tax treatment also differs. CD type annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawn. In contrast, interest earned on traditional bank CDs is taxable annually.
Liquidity also differs; while both may impose penalties for early withdrawals, annuities typically have surrender charges, whereas CDs have bank penalties.
Annuities often include a death benefit feature that can simplify the transfer of assets to beneficiaries, potentially avoiding probate. CDs pass the principal and accrued interest to beneficiaries, which may be subject to probate.
CD type annuities are designed for long-term savings, often for retirement planning, while CDs are used for shorter- to medium-term savings goals.
Tax Treatment of CD Type Annuities
The tax treatment of CD type annuities is primarily centered on tax-deferred growth. Earnings are not subject to taxation until funds are withdrawn. When withdrawals occur, the earnings portion is taxed as ordinary income.
The IRS applies a “last in, first out” (LIFO) rule, meaning earnings are considered to be withdrawn first, making them fully taxable until the earnings portion is exhausted. Withdrawals made before age 59½ may be subject to an additional 10% early withdrawal penalty under Internal Revenue Code Section 72. This penalty applies to the taxable portion of the withdrawal, unless a specific exception applies, such as disability.
For non-qualified annuities, beneficiaries pay ordinary income tax only on the earnings portion; the principal is not taxed again.
Acquiring a CD Type Annuity
Acquiring a CD type annuity involves identifying an insurance company or a licensed agent. The prospective annuity holder will then complete an application, providing personal and financial information. This application initiates the formal contract with the insurance provider.
Once the application is approved, the annuity needs to be funded, through a lump-sum payment, or via a rollover from a qualified retirement account such as an Individual Retirement Account (IRA) or 401(k).
The insurance company issues the annuity contract, which details the terms, guaranteed interest rates, surrender charges, and other provisions. The contract serves as the legal agreement outlining the relationship between the annuity holder and the insurer.