CDs vs. Annuities

Certificates of deposit (CDs) and annuities can both be good ways to save for the future. Both types of investment offer a low-risk, low-return way of investing. However, there are some important differences between these financial products.

The most important is the length of time that each type of investment is designed for. Most people will use an annuity to save for retirement—that is, as a long-term investment. In contrast, CDs are best used for short- to medium-term investments. If you are looking to put aside some extra money for retirement, an annuity can be a good option. If you’re going to need that money in five years’ time, it’s better to go for a CD.

In this article, we’ll explore the differences between these two types of investment in more detail and help you decide which is right for you. 

CDs vs. Annuities: The Key Differences

In order to understand the key differences between CDs and annuities, it’s worth reminding yourself how they work.

A CD is a financial product offered by a bank. When you take out a CD, you agree to leave your money in one place for a set period of time. In exchange, your bank or credit union will pay you a set interest rate on this money, one that is typically higher than other types of savings accounts. The downside is that your money isn’t liquid—you have to leave it in the CD for the whole term you’ve agreed to or you’ll have to pay early withdrawal penalties.

An annuity, in contrast, is essentially an insurance contract. It is issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments. The holding institution issues a stream of payments in the future for a specified period of time or for the remainder of the annuitant's life. There are several types of annuity, but they are mainly used for retirement purposes—to help individuals address the risk of outliving their savings.

The most fundamental difference between a CD and an annuity is when the returns are paid to you and in what form. An annuity will generally pay you a stream of income over time, whereas a CD will pay you a lump sum when it matures. This makes an annuity suitable for people looking to secure a steady stream of income in retirement and CDs more suited to those looking to save money for a short-term goal.

In addition to this fundamental difference, there are also a number of smaller differences between CDs and annuities.

Risk

Both CDs and annuities are regarded as extremely safe investments because both are guaranteed, albeit by different institutions.

CD investments are also protected by the same federal insurance that covers all deposit products. The Federal Deposit Insurance Corporation (FDIC) provides insurance for banks and the National Credit Union Administration (NCUA) provides insurance for credit unions. When you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 of your funds on deposit with that institution are protected by the U.S. government if that institution were to fail.

Annuities aren’t insured by the federal government. However, they are generally insured by the issuing insurance company and, in most cases, also by state guaranty associations. However, it’s important to make sure your annuity is issued by a highly rated insurance company in order to make this protection as strong as possible.

Flexibility

Both CDs and annuities have early withdrawal penalties—that is, both are fairly inflexible investment vehicles because you must leave your money in them for a specified term. However, because annuities are generally designed to be held for a longer period than CDs (until retirement, rather than for just a few years), annuities can have higher penalties than CDs if you need to get your money back in an emergency.

Because of this, investors who are considering purchasing an annuity should carefully consider their financial requirements. Annuities usually have a surrender period, during which you cannot make withdrawals without paying a surrender charge or fee. There are also tax implications for withdrawals before age 59½.

Interest rates

Though annuities are less flexible than CDs, this disadvantage is offset by an advantage—annuities generally pay a higher interest rate than a CD. This is because the financial institution you hold your CD or annuity with is exposed to less risk with an annuity due to the longer length of time you will hold it.

Since federal interest rates are low at the moment, a difference of just 1% or 2% can affect the long-term return on your investments. This can make an annuity a good option for older investors who are unlikely to need the liquidity offered by a CD, who want to keep their investments low-risk, but who also want to earn a reasonable return on their investment.

Tax

The final difference between annuities and CDs is the tax implications of each investment instrument. 

Annuities are designed to be used for retirement and come with tax advantages when used in this way. The interest that your annuity earns is tax-deferred and so you pay taxes only when you start taking withdrawals from the annuity. Withdrawals are taxed at the same tax rate as your ordinary income. If you fund an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan, you may also be entitled to a tax deduction for your contribution. This is known as a qualified annuity.

In contrast, the money you earn through a CD will be taxed as income when the CD matures and you are paid your lump sum. This can make annuities more tax-efficient than CDs, but for most people, the other differences between these investment instruments will be more important than the tax implications of each.

The Bottom Line

Both CDs and annuities are very safe investments. Both offer a set return on your money and both are guaranteed by either the federal government or insurers. 

There are differences, however. CDs can be more flexible than annuities, with shorter terms and lower penalties if you need to withdraw your money in an emergency. However, annuities will generally pay a higher interest rate than CDs. The most fundamental difference between a CD and an annuity relates to the amount of time they are designed to be held for—a CD is best for short- to medium-term investments and an annuity is better for a long-term investment in your retirement.