By Ken Nuss
Fixed rate annuities act much like bank certificates of deposit, but typically pay much higher rates than CDs of the same term.
How can insurers afford to do this? After all, banks and insurers pay a fixed rate. Before answering this question, let’s cover the basics of how each works.
A very popular type of fixed annuity, the guaranteed multi-year annuity, pays a guaranteed interest rate for a period of two to 10 years. There is no sales charge. This is why they are often referred to as “CD type annuities,” but there are some important differences between them and CDs.
Taxation, penalties and liquidity
One is taxation. As long as you reinvest the annuity interest and don’t withdraw it, you won’t pay income tax. Tax deferral allows your interest to accrue faster. At the end of the guarantee period, you can renew for another term or reinvest the entire amount in a new annuity via a 1035 swap and continue to defer taxes.
CD interest is taxable each year when credited, even if it is not withdrawn.
CDs carry penalties for early withdrawal. Fixed annuities too. Withdrawals greater than those authorized by the contract before the end of the surrender period will incur an early surrender charge. However, many fixed rate annuities allow you to withdraw up to 10% of the value annually without penalty; some are more restrictive.
With most CDs or annuities, if you choose to receive interest payments instead of reinvesting them, you won’t be penalized.
Unlike CDs, with an annuity, if you receive interest on it before age 59 and a half, you will owe the IRS a 10% penalty on the accrued interest you withdraw as well as income tax. ordinary income. So don’t buy a fixed annuity if you might need the money before the age of 59 and a half. The IRS will waive the penalty if you are permanently disabled.
Unlike DCs, fixed annuities are not insured by the FDIC, but are covered by state guarantee associations, which provide some protection up to certain limits. Each state has a guarantee association which is backed by life insurers who do business in that state. If your annuity company becomes insolvent, the guarantee association is required to cover the shortfall. In most states, they will cover an annuity of up to $ 250,000, but in a few states it is lower ($ 100,000 in New Jersey and Puerto Rico are the lowest) and in several states, c ‘is $ 300,000, with New York the highest at $ 500,000. Associations offer full coverage up to the limit, except in California, where coverage is 80% not to exceed $ 250,000.
FDIC or NCUA insurance is backed by the United States government. Individual accounts are insured up to $ 250,000.
Additionally, annuity issuers have a good track record and economists consider annuities to be secure, especially if you choose a well-rated insurer.
Fixed rate annuities offer terms of two to 10 years. CDs are generally available with durations ranging from one month to five years. A few banks offer terms of up to 10 years.
Annuity rate Dwarf CD rate
From mid-November 2021, you can earn up to 3.15% per year on a five-year fixed annuity. The higher five-year CD rate was 1.25%, according to Bankrate.
One of the great things about CDs is that they usually have a lower minimum to start with – with some there is no minimum. Most fixed annuities require at least $ 2,500, and some have a considerably higher minimum premium.
Let’s say you have at least $ 10,000 to invest. You could buy a five-year annuity paying 2.80% from an insurer with an AM Best “A” rating. Interest is compounded daily and credited annually. It offers annual withdrawals without a 10% penalty, but the interest portion of those withdrawals will be taxable (any portion that is return of capital is not taxed). If you reinvest all interest instead, you will defer federal and state income tax.
As mentioned above, you will continue to defer taxes on the interest you have accrued. However, if you choose to surrender your annuity and cash it out instead, then you will owe tax on five years of interest if you had allowed all of the interest to accumulate in the annuity.
Here is a roughly comparable CD of an open-ended NCUA insured credit union (NCUA federal insurance is the credit union equivalent of FDIC insurance). The minimum on his five-year CD is $ 1,000, but he pays the same no matter how much you deposit. The APY as of November 23 was 1.25%. The credit union carries a five-star rating for financial strength from Bauer Financial.
Dividends are accrued monthly and are taxable annually. Within 365 days of the opening date of the certificate, the penalty for early withdrawal before maturity will correspond to the last 365 days of dividends earned. After 365 days, the penalty is 30% of the gross amount of dividends that would have been earned if the certificate had expired.
Fixed annuities often outperform DCs at shorter terms as well, and terms of up to 10 years are available. Consult this annuity rate table.
Why insurers can pay more
Why can insurers safely afford to pay more? This is largely determined by what insurers and banks can invest in. Additionally, higher minimum premiums and longer terms can help insurers pay more.
Banks earn their money primarily from loans: mortgages, business loans, and personal loans such as auto loans. The interest rates on most loans are low these days. In addition, banks have to absorb significant overheads and defaults. They don’t have much to pass on to CD buyers.
Fixed annuities are backed by the general account of the insurance company. Life insurers invest in a mix of corporate and government bonds, stocks, mortgages, real estate and policy loans. These investments are often longer term and can offer higher returns than bank loans.
Insurers are primarily regulated by states. The federal government is the primary regulator of banks. These different regulatory systems can offer insurers advantages in terms of cost structure, risk tolerance and investment flexibility.
Consider all the options for guaranteed rates
If you’re looking to get a guaranteed interest rate, don’t automatically jump on a bank CD or fixed annuity for that matter. DCs and fixed annuities each have their advantages and disadvantages, and because of the penalties on annuity withdrawals before 59½, annuities are generally more appropriate for people in their 50s and over. If you don’t have at least $ 2,500 available, you won’t find a lot of fixed rate annuity options.
But annuities have two distinct advantages over CDs: tax deferral and generally higher guaranteed interest rates. Today, it’s easy to shop and compare CDs and fixed annuities online.
About the Author: Ken Nuss
Ken Nuss is the Founder and CEO of AnnuityAdvantage, a leading online provider of fixed income, indexed and life annuities. He is a nationally recognized annuities expert and author. A free rate comparison service with the interest rates of dozens of insurers is available at https://www.annuityadvantage.com/annuity-rates-quotes/multi-year-guarantee-annuities or by calling (800 ) 239-0356.
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