Outside of the fact that both products offer safety of principal and the ability to accrue interest to the value of an account, bank certificates of deposit and indexed annuities are more different than alike. If you are trying to decide on one over the other, the most important factor is your goals for the money you will be investing.
A certificate of deposit is a savings contract for a fixed term, paying a set interest rate. You can get a CD at any bank. Annuities are retirement savings contracts sold by life insurance companies. A deferred annuity earns interest until a decision is made to make withdrawals in retirement. An annuity offers a range of ways to draw an income in your retirement years. The specifics of individual CDs and annuities depend on the bank or insurance company offering the product.
Probably the reason you are considering an indexed annuity is the potential for significantly higher interest earnings than those paid on bank CDs. The rate earned on an indexed annuity is based on the return of a stock market index. For example, an annuity may pay 80 percent of the gain of the S&P 500 stock index with a guaranteed minimum rate if the index goes down instead of up. A CD pays a fixed rate for the term of the certificate. The choice of an indexed annuity involves the potential of significantly higher interest earnings traded against the guaranteed but potentially lower return from a CD.
CD terms range from 30 days to five years, with longer-term CDs occasionally available. At the end of the term you can use the money, reinvest in another CD or invest elsewhere. An indexed annuity will have surrender fees for 10 to 15 years after you purchase the contract. You are locked into the annuity for the long term. Also, the tax rules will impose extra penalties if you take out money before age 59 1/2. So buying an annuity in your 20s or even as late as your mid-40s requires a long-term commitment.
Tax On Earnings
Interest earned on a CD is taxable income. You get a Form 1099-INT each year listing the CD interest you made, and you include those earnings on your tax return. Even with a five-year CD you pay taxes every year. An annuity grows tax-deferred. The earnings on an indexed annuity will not be taxable until you make some sort of withdrawal. From a tax perspective, the long investment period required by an annuity contract will result in significant compounded growth of the account value. With CDs, paying taxes on the interest every year reduces the effect of compound interest.
The function of a CD is simple: You invest an amount of money, it earns so much in interest, and it matures on a certain date. Indexed annuities are anything but simple. The Financial Industry Regulatory Authority has an investor alert web page that discusses the complexities of indexed annuities. When considering one of these annuity contracts, you need to understand how interest is earned, how it is credited, and how you track what is going on with your investment.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.