Earning More- CDs versus Fixed Annuities

Will Rogers once said of investing, “It is not the return on my investment that I am concerned about; it’s the return of my investment.” In appreciation of this sentiment, let’s take a good look at two financial instruments that both have guaranteed return of your principle and guaranteed interest- Certificates of Deposit (CDs) and fixed annuities.

CDs are offered by banks. The bank holds your money for a set term, often in years, for a guaranteed rate of return. CDs typically have early withdrawal penalties. In exchange for giving up that liquidity you usually get more interest- and longer terms typically have higher interest rates. Unless the CD is held in an IRA or other qualified account the interest is taxable as ordinary income. This means that the interest rate that you earn is lower than the stated rate because of the taxes on that interest income (assuming you pay income taxes). That guaranteed interest rate is paid until it matures. At maturity you can take your money, move it to a different CD or financial instrument, or let it renew automatically. CDs are also protected by FDIC insurance.

Fixed annuities are offered by insurance companies. There are different kinds of annuities, and in this article we’re going to focus on Multi-Year-Guaranteed-Annuities (MYGA). Just like CDs they are available for set terms, most often from three to 10 years. Quite often the rates are higher than the same term of CD product. Further, the interest grows tax-deferred. That means that you only pay taxes on the gains when you take the money out. At that time the interest comes out first, and it is also taxed at ordinary income tax rates. If you don’t take the gains out there are no taxes, and the money you’re not paying out to taxes will compound over time. These are retirement savings products and are subject to a 59 ½ 10% penalty rule. This means that if you withdraw earnings before you turn age 59 ½ it would be subject a 10% penalty. Where CDs have early withdrawal penalties, fixed annuities have surrender charges. The features vary by the insurance company and product, but many fixed annuities have 10% surrender free withdrawal privileges after the first year, and some even waive the surrender charges if the owner requires nursing home care. At maturity you can take your money out, let it renew, or do a tax-free transfer to another annuity. Since a guarantee is only as good as the guarantor, it is important to check the financial rating of the company offering the annuity. A-ratings are the best, as companies with that rating are considered to have an excellent ability to meet their obligations.

When considering using a CD or an MYGA annuity it is important to compare the rates and terms. Just like you might shop for a good CD rate at different banks, MYGA annuities often have different rates at different companies- so it is a good idea to shop for those too. Also, higher interest rates are often available for amounts greater than $100,000.

Let’s look at an example. Joe is 70 years old. Aside from his other investments, he keeps $100,000 in CDs and $50,000 in savings for an emergency fund. His local bank is offering him a better rate for having at least $100,000, and that rate is 1% for a 5-year CD. Joe does the math, assuming annual compounding, and paying the taxes on the interest out of pocket. After 5 years, he’ll make $5,101. His income tax rate is 12%, so overall he would pay $612 in income taxes on the interest. He figures that he would really make about $4,489 after taxes. But then he read about MYGA fixed annuities.

Joe finds a good broker of MYGA annuities, and runs down his checklist; the 59 ½ age penalty doesn’t apply to him, he has found someone that can compare annuities from different companies, he likes the terms of the contract, the company is A-rated, and the interest rate for a 5-year term is 2.3%. Joe does the math again, assuming annual compounding. He figures that he’d make $12,041 and that he’d not have to pay taxes on it until he withdraws it. He does a little more math, wondering how he’d do if he took all those earnings right when the term is over. The taxes due at his income tax rate would be about $1,445, leaving him with $10,596. Joe checks his math because that seems too good- it is $6,107 more than the CD. But his math is correct. He invests in the annuity and starts planning his next vacation with his grandkids.

A little knowledge can be a profitable thing.

Thomas Capital Management, LLC, 274 Old Corvallis Road, Suite K, Hamilton, MT 59840. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Thomas Capital Management, LLC are not affiliated. www.thomascapitalmgmt.com