CDs or Annuities: Which Is the Smarter Investment?

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certificates of DepositWith interest rates near record lows, it's tough to make your investments generate the income you need. To get the most from your money, you have to make the smartest investments you can.

For conservative investors, bank certificates of deposit are a time-tested favorite for providing income. But many people have discovered that fixed annuities seem to offer similar terms with better rates.

So which investment is the smarter way to get the income you need?

Play it safe, or safer?

Bank CDs are among the safest investments available, as they're federally insured up to $250,000. Even if your bank fails, the FDIC will make your account whole.

By contrast, fixed annuities aren't FDIC-insured even if you buy them at a bank. They are guaranteed by the insurance company that issues them, so it's the company's financial security that determines how safe they are.

There's a risk-reward trade-off, however:
  • Lately, rates on CDs have been extremely low, with one-year CDs paying 1 percent or less. Even five-year CDs fall short of the 2 percent mark.
  • By contrast, fixed annuities offer somewhat better rates. A recent search revealed three-year fixed annuities paying more than 2 percent and longer-term annuities paying 3 percent or more.
The ups and downs of annuities

Annuities come with some other benefits as well. Unlike bank CDs, annuities generate income on a tax-deferred basis, letting you avoid paying tax on the interest until you take the money out of the annuity.

When it comes to getting timely access to your money, annuities and CDs differ. Typically, even if you need to withdraw CD money early, you can simply pay an early-withdrawal penalty equal to three to six months of interest. At 1 percent to 2 percent, that's not usually a huge amount.

On the other hand, many annuities allow you to withdraw a small amount of your money -- often up to 10 percent -- without paying surrender charges, but above that, the cost can be much higher. In addition, if you're younger than age 59 1/2, you'll also have to pay an IRS withdrawal penalty of 10 percent of your interest.

You also have to be careful to understand the guarantees of the particular fixed annuity you choose. Some annuities only guarantee interest rates for an initial period, with rates moving up and down after that. Other annuities guarantee a rate for the entire period.

Which should you pick?

Whether a CD or an annuity is smarter for you depends on your specific financial needs. The key in deciding is to understand that despite looking similar, CDs and annuities are very different. Don't automatically pick an annuity for its higher rates before you understand their features and obligations.

Follow Motley Fool retirement expert Dan Caplinger on Twitter @DanCaplinger.

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