A certificate of deposit (CD) is a secure investment that earns interest for you. Using a fixed annuity is sometimes compared with using a CD. Let's see how fixed annuities are different and possibly more advantageous.
A CD earns interest income for you that's taxed every year as ordinary income. And you're penalized for taking your money out before the CD's term is finished. Fixed annuities earn interest income too, but it's tax-deferred.
*Assuming you're older than 591/2, how can you can take money from a fixed annuity?:
You can choose either a deferred fixed annuity or an immediate fixed annuity for growing your savings and taking income.
In the case of a deferred annuity, you can take interest income out at any time but there's still a percentage penalty if you take out your initial deposit - like in the case of a CD. This penalty - perhaps 4 or 5% - decreases over the surrender period of your annuity. The surrender period varies but may average around 7 years.
However, some annuity contracts allow you to withdraw as much as ten percent without the penalty. Many contracts allow you to take its interest earned penalty-free each year - but taxed. That's why some people use deferred annuities just as they'd use a CD.
But no matter how much you take out of your deferred annuity, all the interest earned by it since you began the contract will be presumed to come out first. And that's taxed as ordinary income.
An immediate fixed annuity pays you a lifetime income - generally monthly. But each payment is only partially taxed - part is from earned interest of the premium money you paid for the immediate annuity and part for return of your principal - i.e. the premium, itself, you paid for the annuity. The money that remains in the contract (i.e. your immediate fixed annuity) earns interest which grows tax-deferred until you take some of that interest out.
The amount of that interest is fixed by the contract. Therefore, the total earnings you'll receive from your principal (premium paid) according and up to your life expectancy at the time you started the immediate annuity is known.
*A fraction of each annuity payment is tax free:
Now each monthly payment is fixed according to the contract and so is the fraction of each payment that is tax free and the remaining fraction that is taxable. That's because, your premium you paid (i.e. the contract principal) is known and - based on your life expectancy at the start - the total amount of earnings you'll receive is known since that interest is fixed by the contract.
With these known, the fraction assigned to each payment is simply the ratio of your principal (the premium you paid) to the total amount you're supposed to receive back over your life expectancy composed of your total return of principal and all its earnings. And the fraction that will be taxed for each payment (for the year that payment was received) will be the ratio of the total earnings you'll receive over that same total return of principal and earnings.
Incidentally, after you've received all your principal back in those monthly payouts, all future payouts are fully taxed as income. But that's occurs when you live beyond what your life expectancy was when you began your annuity payouts.
*The immediate annuity advantage over the CD:
For the immediate annuity, and depending on your age, you may have about 50% or more of each payment tax free. That, along with the annuity's lifetime payout, is their advantage tax advantage over a receiving earnings income from a CD.