What Is the Difference Between a CD and an Anuity?

Certificates of Deposit (CDs) and Annuities are distinct financial products. While both can contribute to financial growth, they are structured differently and cater to varying needs and timelines. Understanding their characteristics helps in determining which option aligns best with specific financial goals.

Understanding Certificates of Deposit

A Certificate of Deposit (CD) functions as a savings account designed to hold a fixed sum of money for a predetermined period, known as its term. In exchange for committing funds for this duration, the issuing financial institution pays a fixed interest rate. This arrangement provides a predictable return on the deposited amount.

CDs are primarily offered by banks and credit unions, making them widely accessible. A significant feature of CDs is their insurance coverage; those purchased from banks are typically insured by the Federal Deposit Insurance Corporation (FDIC), while those from credit unions are insured by the National Credit Union Administration (NCUA). This insurance protects deposits up to $250,000 per depositor, per insured institution, for each account ownership category, safeguarding the principal and accrued interest.

The terms for CDs can range from a few months to several years, with longer terms generally offering higher interest rates. Investors deposit a lump sum, and the interest accrues over the CD’s term. Upon the maturity date, the original deposit plus the accumulated interest becomes available for withdrawal without penalty.

However, withdrawing funds from a CD before its maturity date typically incurs an early withdrawal penalty. This penalty is commonly calculated as a forfeiture of a portion of the interest earned, often ranging from three months to one year of interest, depending on the CD’s term and the institution’s policies. In some cases, if the penalty exceeds the accrued interest, it may even reduce the original principal.

Interest earned on a CD is generally considered taxable income in the year it is earned, regardless of whether the CD has matured or the interest has been withdrawn. This means that even if the funds remain locked in the CD, the interest must be reported on annual tax returns and is subject to ordinary income tax rates.

Understanding Annuities

An annuity is a contract between an individual and an insurance company, structured to provide regular income disbursements, often during retirement. The individual makes payments to the insurance company, either as a single lump sum or through a series of contributions over time. In return, the insurer commits to making periodic payments back to the contract holder, which can begin immediately or at a future date.

Annuities typically involve two main phases:
Accumulation Phase: Money contributed grows on a tax-deferred basis through investments or interest. During this period, earnings are not taxed until they are withdrawn, allowing for potential compounding.
Annuitization Phase: The contract begins to make payments to the holder, which can be structured for a specific number of years or for the rest of their life.

There are several types of annuities, each with different growth and payout characteristics. Fixed annuities offer a guaranteed minimum interest rate and provide predictable, fixed payments during the payout phase, with the insurance company bearing the investment risk. Variable annuities, in contrast, allow the contract holder to choose investments in underlying sub-accounts, such as stocks or bonds, meaning returns and payout amounts can fluctuate with market performance, introducing investment risk.

Indexed annuities combine aspects of both fixed and variable types. They offer a guaranteed minimum return, alongside the potential for additional earnings linked to the performance of a specific market index, such as the S&P 500. These returns are typically subject to caps on gains and participation rates, which limit how much of the index’s performance is credited to the annuity.

Unlike bank deposits, annuities are not insured by the FDIC. Instead, they are protected by state guarantee associations, which provide a safety net if an insurance company becomes insolvent. Coverage limits vary by state but commonly range from $250,000 to $300,000 per policyholder for annuity contracts.

Annuities often come with various fees that can impact overall returns. These can include administrative fees, which might be around 0.3% of the contract value, and mortality and expense risk charges, typically ranging from 0.5% to 1.5% annually, especially in variable annuities. Investment expense ratios for underlying sub-accounts can also range from 0.6% to over 3% per year.

Annuities frequently have surrender charges if funds are withdrawn before a specified period, usually ranging from 5 to 10 years, with initial charges often between 7% and 10% and decreasing over time. While some contracts allow penalty-free withdrawals of a small percentage (e.g., 10%) of the account value annually, surrendering the contract early can result in substantial fees. Commissions paid to agents, typically built into the contract and ranging from 1% to 8% depending on the annuity’s complexity, also contribute to the overall cost.

The growth within an annuity is tax-deferred, meaning taxes on earnings are postponed until withdrawals begin. When funds are withdrawn, the earnings portion is taxed as ordinary income. Additionally, withdrawals made before age 59½ may be subject to a 10% early withdrawal penalty from the IRS, on top of any surrender charges from the insurance company.

Comparing CDs and Annuities

Certificates of Deposit and annuities differ significantly in their structure, purpose, and associated protections. CDs are issued by banks and credit unions, while annuities are contracts offered by insurance companies. This distinction in issuers means their guarantees and regulatory oversight also vary.

A key difference lies in their insurance. CDs benefit from federal deposit insurance provided by the FDIC or NCUA, covering up to $250,000 per depositor, per institution, per ownership category. Annuities, conversely, are not federally insured; their protection comes from state guarantee associations, which offer varying levels of coverage, often around $250,000 to $300,000 per policyholder.

The investment goals for these products also diverge. CDs are generally suited for short to medium-term savings and capital preservation, providing predictable, lower returns for funds that need to remain secure. Annuities, on the other hand, are designed for long-term objectives, particularly retirement income and tax-deferred growth, offering mechanisms for a steady income stream in later life.

Liquidity is another area of contrast. CDs impose early withdrawal penalties, which can be a forfeiture of several months’ interest, potentially impacting the principal if interest earned is insufficient. Annuities have surrender charges for early withdrawals, which can be substantial, especially in the initial years of the contract, typically lasting five to ten years. While some contracts allow penalty-free withdrawals of a small percentage (e.g., 10%) of the account value annually, full access to funds is generally restricted during the surrender period.

Tax treatment also presents a notable distinction. Interest earned on CDs is taxable annually as ordinary income, regardless of whether the funds are withdrawn. Annuities, however, offer tax-deferred growth; earnings are not taxed until withdrawals begin, which can be advantageous for long-term planning, particularly for individuals who anticipate being in a lower tax bracket during retirement. When annuity withdrawals occur, the earnings are taxed as ordinary income, and if taken before age 59½, an additional 10% IRS penalty may apply.

In terms of complexity and fees, CDs are relatively straightforward financial instruments with clear interest rates and minimal fees, primarily early withdrawal penalties. Annuities, conversely, can be complex, with various types and a range of fees including administrative charges, mortality and expense fees, investment management fees, and surrender charges. Commissions paid to agents, typically embedded in the contract, also contribute to the overall cost structure of annuities.

Finally, the potential for interest or return differs. CDs typically offer fixed and generally lower rates of return, providing stability and predictability. Annuities, especially variable and indexed types, offer the potential for higher returns linked to market performance, though this also introduces greater risk and the possibility of lower returns or even losses depending on the market and the specific annuity structure. Fixed annuities provide guaranteed rates, but these may still be lower than the potential growth of other annuity types.