Annuity vs. CD: Which Is Better for Retirement?

Kevin Dyreson is a senior director of Insurance Solutions at Northwestern Mutual.

When it comes to saving for retirement, you’ve got a lot of options to consider. Which savings options make the most sense for you will depend on your timeline, your goals and your risk tolerance.

As you approach (or are in) retirement, you may be looking for more low-risk options, like an annuity or a certificate of deposit (CD).

Read on for some help in understanding the differences and similarities between annuities and CDs so you can decide whether one—or both—belongs in your portfolio.

What is an annuity vs. a CD?

An annuity is a contract between you and an insurance company that is designed to provide reliable income in retirement. Different types of annuities work slightly differently, making some better suited to people in different stages of retirement planning.

There are two main categories of annuities:

1. Income annuities: Through an insurance company, you purchase (often with a lump sum) an income annuity, which will pay you income for a stated period or for the rest of your life. This income can start immediately or at a date set in the future. These are commonly referred to as immediate income annuities and deferred income annuities, respectively.
2. Accumulation annuities: An accumulation annuity is a financial product that you purchase with the intent to grow your money. The money can grow at a fixed rate (fixed accumulation annuity), at a variable rate based on performance of the underlying subaccount allocation (variable annuity) or based on changes to an index (index annuity). The future balance can be used to create income, but it is not required to do so.
   
   

A certificate of deposit is essentially a type of savings account offered by banks in which you pledge to leave your money deposited for a certain period of time, usually in exchange for a higher interest rate than you would receive if you left your money in a regular savings account. CDs are insured by the FDIC making them a low-risk way of growing savings or generating income.

What types of annuities are most like CDs?

A fixed accumulation annuity is most similar to a fixed-interest CD¹ in that you’re putting money toward a financial option that will grow your money over time. When people compare CDs to annuities, they’re usually talking about fixed annuities. Like fixed annuities, fixed-interest CDs will grow your money at a rate that stays the same for a set period of time.

Annuities and CDs are also similar in that they are considered lower risk ways to grow savings. Specifically, there is a low risk that an investor will lose their principal if they invest through a fixed annuity or CD, though there are other investment risks to consider, such as inflation risk.

Should you get an annuity or a CD?

It depends on what your goal is. If you’re trying to set aside money to use for income in retirement, an annuity may be a great option. A CD can be used for more than just retirement income. If you’re looking for somewhere to grow money that you can use for purposes beyond retirement, a CD may be a great option.

But everyone’s situation is different. Your financial advisor may have recommendations for you that involve one or both of these financial options. It’s best to look at your financial big picture when deciding to add any financial option to your portfolio.

When deciding which option to add to your portfolio, here are some other things to consider:

Security and low-risk nature

With both fixed annuities and CDs, there is a low risk that you will lose your principal. While both CDs and annuities offer safety of principal, CDs carry slightly more protection against principal loss due to their FDIC insurance.

CDs are insured—up to $250,000 per depositor, per insured bank—by the FDIC, a government agency. This insurance means that if you deposit money into a CD and the bank fails, the FDIC guarantees you will not lose your principal, up to those limits.

Annuities, on the other hand, are not FDIC insured. Instead, they’re backed by the insurance company that issued your annuity³. Because of the long-term nature of annuities, it’s a good idea to look for insurance companies that have the highest financial strength ratings.

Short-term vs. long-term investing

To achieve desirable growth with a fixed accumulation annuity, you’ll want to give your money time to grow. So, a fixed accumulation annuity can be a great long-term strategy to get steady income in retirement. If you’ve got years until you’re looking to retire, an annuity could be worth a look.

CDs, on the other hand, come in a variety of terms that can be better suited for short-term growth. Some CDs carry terms as long as five years or more while other CDs have shorter terms, with some as short as three months. You can typically withdraw funds from your CD early, but doing so usually means you will give up some or all of the interest you earned (as defined in your terms)³.

Interest and returns

The interest rates offered by CDs are typically higher than those offered by savings accounts but lower than what is offered by fixed annuities. The reason? Time.

Because fixed annuities are playing the long game, insurance companies have the flexibility to drive more value in their investment strategy, which typically translates into higher interest rates. CDs typically carry shorter terms, leaving banks with less flexibility to optimize yield.

Another important difference is the fact that the interest rates offered by CDs can vary substantially depending on the underlying interest rates set by the Federal Reserve. So, while interest rates are locked in for the term of a fixed-interest CD, once the CD has matured, that guarantee goes away. If you’re in the habit of rolling over your CDs, this means you may have to settle for different rates more often with shorter term lengths. The interest rates offered by fixed annuities tend to have longer terms and may include guaranteed minimum interest rates when the terms mature³.

Tax considerations^3,4

Interest earned from CDs and annuities are treated differently come tax season.

The IRS requires you to pay income taxes on the interest earned from a CD in the year in which it’s earned—regardless of whether the CD has matured. You’ll be taxed at your ordinary income tax rate.

With a fixed annuity, you are not taxed on any growth until you receive money from the annuity. This could be through a withdrawal or through income payments. If you continue to defer the fixed annuity, you will also continue to defer any ordinary income tax.

A withdrawal from a fixed annuity will be taxed as gains first, and then your basis would be removed. If you decide to use the fixed annuity to create income, that taxable amount receives what is called “exclusion ratio treatment.” That means the taxable amount will be spread over the income payments. A portion of the income will be a return of basis and taxable gains.

Which is better, a CD or an annuity?

Choosing a CD or an annuity requires you to consider a lot of different factors. Ultimately, what you plan to use those funds for should help guide your decision. Your Northwestern Mutual financial advisor can help you better understand both options and how they may fit within your broader financial plan.

¹Brokered CDs are sold in the secondary market. The secondary market for long-term CDs may be limited. You should not rely on the possible existence of a secondary market for any benefits, including achieving trading profits, limiting trading or other losses, realizing income prior to maturity or avoiding early withdrawal penalties. CDs are subject to price fluctuations. If sold prior to the maturity or call date, CDs may be worth less than their original cost which could result in a loss of principal.

²Northwestern Mutual continues to have the highest financial strength ratings awarded to any U.S. life insurer by all four of the major rating agencies: A.M. Best Company, A++ (highest), 8/24; Fitch Ratings, AAA (highest), 7/24; Moody's Investors Service, Aaa (highest), 8/24; S&P Global Ratings, AA+ (second highest), 4/24. Third-party ratings are subject to change. Ratings are for The Northwestern Mutual Life Insurance Company and Northwestern Long Term Care Insurance Company.

³Guarantees in an annuity are backed solely by the claims-paying ability of the issuer, but do not apply to the investment sub-accounts in a variable annuity which are subject to market risk. Withdrawals from annuities may be subject to ordinary income tax, a 10 percent IRS penalty if taken before age 59 ½, and contractual withdrawal charges. Income annuities have no cash value. Once issued, this annuity cannot be terminated (surrendered), and the premium paid for the annuity is not refundable and cannot be withdrawn.

⁴This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.