If you are saving for the long term, fixed annuities provide you with a steady return and tax-deferred earnings. However, these products have some drawbacks, including tax penalties if you withdraw any money before you reach retirement age. There are a number of investment options that provide you with the same tax benefits and the potential for similar or even greater levels of return.
Certificate of Deposit
Fixed annuities have a term time that can last for five years or more. You receive a fixed rate of return on your investment for the annuity term. Bank and credit union certificates of deposit work in the same way. You lend your money to the bank for a number of months or years and the financial institution pays you a fixed rate of interest in return for the loan. Unlike annuities, CDs are federally insured up to $250,000. If your bank goes bust, then you receive a check from the government-backed insurer. The federal government does not insure annuities, although some are covered by state-administered guarantee funds. Interest rates on CDs and annuities are often similar, although your earnings on a regular CD do not grow on a tax-deferred basis.
Variable annuities are similar to fixed annuities in the sense that both products grow tax deferred and are designed to provide you with an eventual income stream. However, your returns on a variable annuity are based upon the performance of underlying mutual funds. If the market goes up, you make money, but you could lose some of your nest egg if the market tanks. However, some of these contracts include a minimum guarantee, which means you get your original investment back in the form of a lifetime income stream if the contract drops in value. As with fixed annuities, variable annuities are not federally insured but are covered by some state guarantee funds.
Regular bank accounts such as CDs and savings accounts are taxable, but you can also open these account types within an Individual Retirement Account. You can make contributions to an IRA CD or savings on an annual basis, although contributions are subject to income restrictions. As with an annuity, you have to pay income tax on your withdrawals. You also have to pay a 10 percent tax penalty if you withdraw money from any kind of tax-deferred investment before reaching the age of 59 1/2. You do not pay the penalty if you make a withdrawal after becoming disabled. If you establish a Roth IRA, your contributions are made after tax, which means you only pay income tax and the tax penalty on your earnings. If you leave Roth funds alone for five years and until you are 59 1/2, though, you do not even pay income tax, even on the earnings.
Bonds are negotiable debt instruments that have terms ranging from a few months to 30 years. If taxes are a concern, you can invest in general-obligation municipal bonds. Income payments from these bonds are generally exempt from federal income tax. You also avoid paying state income tax if you buy bonds that were issued in the state where you live. You can hold your bonds to term or sell bonds to another investor if you need access to cash. Unlike annuities, you do not have any age restrictions to contend with or early-withdrawal penalties. However, bonds can lose value if the issuer goes bankrupt or just lacks the cash to cover the interest payment.