Indexed Annuities vs. Bonds & CDs: Maximize Growth & Minimize Risk in Retirement
By John Jones
Investing is key when it comes to growing your retirement savings, but sometimes risk, tax liabilities and the amount of growth potential can deter someone from breaking into the market. Bonds and CDs are traditional investment products that offer safety, income generation and predictability. However, the interest generated from these products is generally taxed as overall income, which can limit returns, especially for those with higher incomes. In times of economic uncertainty, specifically during periods of rising interest rates, bonds can lose value which could result in a loss if sold before maturity. When it comes to inflation, CD rates are typically fixed and can be lower than inflation, offering minimal returns. However, there is a product out there that can minimize risk while also providing growth potential and tax advantages: indexed annuities.
With investing products in general, it’s important to know there is always a risk-return tradeoff. Either earnings or a time commitment is traded for minimizing risk. When it comes to indexed annuities, a big benefit for many investors is the protection it provides. However, the tradeoff is the time commitment.
For many indexed annuities, there is a set amount of time where you could be penalized if you withdraw more than a certain percentage of your money. This is known as the surrender period. The purpose of the surrender period is to encourage you to keep your money in the annuity for this period to allow it to grow. It also allows the insurer to continue managing the investment. However, most indexed annuities allow you to make penalty-free withdrawals. In most cases, you can withdraw up to 10% of your initial investment each year without triggering a surrender charge. This can provide you with some flexibility to access some of your funds without being penalized.
As for bonds, you can sell them before maturity, however, if interest rates have changed you risk not getting back your full potential. Bonds are also traded on the secondary market, which causes their values to fluctuate based on interest rates and market demand. Depending on the type of bond you have, it might be harder to sell. For example, government bonds are typically liquid and easy to sell, but their prices fluctuate. As for corporate and municipal bonds, they may have a smaller market, which can make them harder to sell without taking a loss
If you’re invested in a traditional CD, these products hold your money for a fixed term. If you withdraw early, you’ll likely be penalized. For short-term CDs, you can expect to pay three to six months of interest. For long-term CDs, the penalty could be six to 12 months of interest. Some banks do offer no-penalty CDs that allow you to make early withdrawals and you won’t be charged a fee if they’re made after the waiting period. However, they typically offer lower interest rates than standard CDs.
Indexed annuities have the potential to provide higher returns because they’re tied to the performance of a market index, such as the S&P 500. However, it’s important to note that these products don’t directly invest in the index itself. Instead, the insurer uses the index’s performance as a benchmark to determine the annuity’s return.
Most indexed annuities also come with what’s called a “floor” to prevent you from losing money. Usually, the floor is 0%. Therefore if the index goes down, your account value won’t fall, but you also won’t gain anything. This is a pretty big selling point for investors. However, it should be noted that there are usually caps or participation rates that limit the amount you can earn from the index’s gains. So, if the S&P grows by 15%, but your annuity is capped at 10%, your return for the year will be 10%, not 15%.
As for bonds and CDs, they generally offer lower returns than indexed annuities due to their structure, risk level and investment strategy. CDs specifically are low-risk, fixed-income investments that are offered by banks. Therefore, their returns are limited due to their guaranteed fixed interest rates. Because CDs are FDIC-insured, CDs come with minimal risk and lower yields. Banks also use your investment to offer loans with interest rates that are higher than what they’ll pay you for your investment. This allows them to make a profit off the difference.
With bonds, these products are fixed-income securities, meaning you lend money to a government or corporation in exchange for interest payments. However, most bonds pay a set interest rate and return your principal at maturity. Just like CDs, they’re lower risk investments, which means their returns are lower. And, if you need to sell the bond early, the value can decrease if interest rates rise. This adds potential risk with no additional returns.
Managing tax liabilities is another attractive feature for investors and indexed annuities can provide tax advantages. The growth on these products is tax-deferred, which means you won’t pay taxes on the interest or gains until you start withdrawing funds. Plus, by taking those penalty-free distributions, you can minimize the taxes as opposed to taking a lump-sum distribution, which could push you into a higher tax bracket.
With bonds and CDs, the interest is taxed each year as ordinary income. While the interest made on municipal bonds is federally tax-exempt, this doesn’t mean it can’t impact your overall tax situation, particularly when it comes to Social Security taxation and Medicare’s income-related monthly adjustment amount (IRMAA).
There are various products out there for you to invest in, but it’s important to remember that each comes with their own level of risk and return. Depending on your specific goals, one product might work better than another. To find the best fit for you, consider meeting with a financial adviser who can analyze your situation and offer guidance.
About the author: John Jones
John Jones, an investment adviser representative at Heritage Financial, has been working successfully in the financial world for almost a decade. He has a broad and specialized knowledge in securities, financial planning, wealth management and taxes.
John attended Saint Leo University online and obtained his Bachelor of Arts in Accounting. Shortly after, John received his Chartered Financial Consultant (ChFC®) designation from The American College of Financial Services. He is an enrolled agent (EA) with the Internal Revenue Service and is Bucket Plan Certified® (BPC®).
