Like so many Americans, my clients Don and Sue have bank Certificates of Deposits (CDs) maturing on April 15th. The renewal rate on their CDs will be less than 1%. Are you in this situation as well? According to Stephani Lucas, annuity expert and CEO of The Annuity Consultants Inc., more CDs mature in April than in any other month. With interest rates so low, I encourage you to consider other options before you automatically reinvest. One good option, favored by ex-Federal Reserve Chairman Ben Bernanke in his own portfolio, is the purchase of annuities. Annuities offer an appealing and stable alternative to your classic CDs.
Advantage of annuities over CDs
The main advantage of annuities over CDs is that they generally pay a higher rate of return. We are currently in a very low interest rate environment. CDs are paying approximately 1% for a one year CD and up to 1.35% for a three year CD. Some fixed annuities, on the other hand, are paying 2% for two years, 3.1% for five years, and up to 3.6% for ten years.
But it is not only about interest rates. When choosing between a CD and an annuity, your investment time horizon is very important. CDs are often better for the short-term cash accumulation… the down payment on a house or the purchase of a new car. Annuities are better for long-term accumulation… investments that will last to and beyond age 60.
Because they are intended as long-term investment vehicles, annuities receive preferred tax treatment by the IRS. Whereas CD interest is taxed annually, annuity interest is not taxed until the money is withdrawn. Annuity earnings grow on a tax-deferred basis, and you may be in a lower tax bracket when you finally withdraw the money. Because of this favorable tax treatment, however, the IRS charges a 10% penalty on earnings withdrawn from an annuity before age 59 ½.
For those who have CDs and are paying long-term care insurance, the Pension Protection Act of 2006 creates a unique planning opportunity. You can move your CD investment into an annuity, take the earnings out of the annuity and use them to pay the premiums for your long-term care insurance or any other long-term care expenses. Not only will you typically earn a higher rate of return with the annuity, the withdrawal of the earnings is tax-free when it applies in the above two situations, and you will also avoid the early withdrawal penalty of 10%, even if you are not yet 59 ½ years old.
CDs and annuities differ in their treatment under probate law as well. CDs are subject to the probate court process, and delays are the norm. It can take a long time before your beneficiaries receive proceeds from your CD. Annuities do not have to go through probate. Annuity owners name primary and contingent beneficiaries when they set up the annuity, and beneficiaries quickly receive the money after the death of the owner.
Types of annuities
Should you decide that you are interested in an annuity, they come in two basic ‘flavors’ – fixed and variable. A fixed annuity has a guaranteed interest rate, while a variable annuity allows you to invest in accounts that are similar to mutual funds and fluctuate with the market.
A hybrid third option, called an indexed annuity, is a type of fixed annuity in which the investment is tied to the movement of a certain index, such as the S&P 500. An indexed annuity usually guarantees a minimum rate of return but puts a ceiling on the maximum return that can be earned as well. You will not get all of the return of the chosen index when it does extremely well, but you will receive the guaranteed interest rate regardless of how poorly the chosen index performs. This allows the owner to avoid the wide fluctuations of a variable annuity but still have the possibility of earning greater returns than a traditional fixed annuity.
So, don’t let your current CD renew for another year at 1% or less. Look for other options that still provide security with downside protection and upside potential.
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Written by R. J. Kelly – April 2014