Not everyone is able to stomach the volatility of the stock market. Sure, if you’re young or have an appetite for risk, you can manage the daily gyrations of the stock market without losing your lunch (or your investments funds). But what if you DON’T have the appetite for risk? What if you’re more concerned about preserving capital and producing steady income than making outsized gains on your investments?

You could invest in bonds, but bond prices can rise and fall. You might receive a coupon at a fixed rate, but the value of your investment can still fluctuate. Bonds are safer than stocks, but what’s safer than bonds? Two of the most common (and safest) investment vehicles are annuities and certificates of deposit (CDs) which offer modest returns but don’t put any principal at risk in the process. However, these products aren’t interchangeable and have different rules when it comes to taxes and guarantee of principle. Today, we’ll compare the benefits of both, and discuss which option works best for savers nearing retirement age.

What is a Multi-Year Guaranteed Annuity (MYGA)?

Annuities are insurance products that can provide a fixed or variable rate of interest of a lump sum of capital over a specific time frame. Most variable annuities are tied to some type of market index, but fixed rate annuities provide the same steady rate of return regardless of market impact. A MYGA is a type of fixed rate annuity where the return is set over a longer period of time, like 3, 4 or 5 years. Some MYGAs can span an entire decade.

A MYGA is offered by an insurance company and like all annuities, there’s an accumulation phase before any premium is returned. Any withdrawals made during this phase will be subject to a penalty, although some companies offer riders that allow accumulation phase withdrawals in certain situations. You won’t be able to receive your premium and interest until after the term of the annuity, but the interest grows tax-free. MYGA holders won’t owe taxes until the money is removed from the account.

What is a Certificate of Deposit (CD)?

You might be more familiar with certificates of deposit, or CDs, since they’re offered by almost every bank and brokerage in America. Like a MYGA, a CD is a risk-free product that guarantees a fixed return over a certain period of time. Your premium will be locked up for the entirety of the term, after which you’ll receive your premium back plus interest. CD rates vary depending on the term. Higher rates can be attained with multi-year CDs, but there are also options for as short as 3 to 6 months.

In terms of structure, CDs and MYGAs are quite similar. You must agree to keep your principal in the custody of a bank or insurance provider, who then returns the money (plus interest) when the term of the product ends. But there are a few crucial differences in terms of taxes and customer protection that prospective buyers must understand.

Key Differences Between the Two Products

Tax Status – MYGAs and CDs are taxed differently. When buying a CD, you must pay taxes on the interest every year, even if you haven’t received your premium back yet. This doesn’t come into play with shorter term CDs like the 3 and 6-month variety, but multi-year CDs will require some extra cash for taxes. MYGAs offer tax-deferred growth, so you won’t pay taxes until the premium and interest is returned. CDs can receive tax-deferred status if kept in an IRA though.

Security of Premium – CDs are insured by the Federal Deposit Insurance Corporation (FDIC), which is the cream of the crop in terms of principal protection. Should the bank or broker that issues the CD go under, the federal government guarantees the return of your principal. MYGAs are guaranteed by the insurance company offering the annuity, and obviously insurance firms have a greater chance of failure than the federal government. However, each state offers some form of guarantee protection for annuities.

Which Product is Best for Me?

The decision to use a MYGA or CD is a matter of personal preference. CDs tend to be better served for those looking for shorter terms, while MYGAs work better over a 5 to 10 year time horizon. But there’s more to consider than just rates. Both products are safer than traditional stocks and bonds, but only CDs are FDIC insured. Additionally, taxes must be part of the equation too. CDs held in non-qualified accounts will be taxed annually while MYGAs are only taxed at the end of the term.

Of course, there’s no rule against having both a CD and MYGA. One popular strategy is to create an income ladder using both CDs and MYGAs and setting them to end at different points. For example, a series of short-term CDs (1 to 2 years) and longer-term MYGAs (3 to 5 years) can create a rolling income stream. When the term of the first CD expires, the interest can be used as income while the principal is rolled into a different product.

Disclosures

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity. Annuities are not FDIC insured. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59½ are subject to 10% IRS penalty tax. Surrender charges apply. Guarantees are based on the claims paying ability of the issuing insurance company.