May 20, 2024

Investment News: Maximizing CD Rates and Fixed Annuities

In recent months, I’ve had quite a few people come to me excited about the 5% interest rates they’ve been offered on short-term certificates of deposit (CDs). It’s great to see such enthusiasm, but there’s often confusion about how these rates actually work. Many people think that a six- or nine-month CD at 5% means they’ll earn that percentage over the course of the entire term. In reality, that’s not quite how it works.

Understanding Annual Percentage Yield (APY)

When you’re quoted a 5% interest rate on a CD, that’s actually the Annual Percentage Yield (APY). APY reflects the total amount of interest you’ll earn over a full year, not a shorter period like six or nine months. So, if you’re putting your money in a six-month CD at a 5% APY, you’re really earning half that rate for the six-month term — which comes out to 2.5%. The same goes for a nine-month CD, where you’ll earn 75% of the full year’s interest, not the entire 5%.

Despite this, these CD rates are still solid, and they represent a good opportunity for savers in today’s environment. My advice is to lock in the longest-term CD you can find at a rate close to 5%, as longer-term CDs tend to have lower rates. However, if you search diligently, you might find a one-year CD offering around 5%, which can be an excellent option for short-term savings.

How CDs Fit Into Your Financial Strategy

For many people, CDs can be a great place to park some of their short-term cash reserves. For those familiar with my Happy Bucket concept, this refers to funds set aside for short-term needs, emergencies, and peace of mind. CDs can play a significant role here, especially when interest rates are favorable. However, it’s important not to put all of your Happy Bucket money into CDs—just enough to take advantage of the attractive rates while maintaining some liquidity.

The Appeal of Fixed Annuities

If you’ve maxed out your Happy Bucket and have extra funds that you don’t anticipate needing in the short term, fixed annuities may offer an attractive alternative to CDs, especially for longer-term commitments. Fixed annuities are currently offering rates well into the 5% range, and the terms can stretch from two years to as long as 10 years.

One key advantage of fixed annuities over CDs is that they offer tax-deferred growth. Unlike CDs, which generate a 1099 tax form for the interest you earn each year, fixed annuities allow your interest to grow tax-deferred. You won’t pay taxes on your gains until you start withdrawing money from the annuity, which could be many years down the line. This can be a significant tax advantage, particularly for retirees who want to minimize their current taxable income and preserve more of their Social Security benefits.

Tax Implications of CDs vs. Annuities

Let’s break this down with an example: Suppose you invest $100,000 in a CD earning 5% interest. At the end of the year, you’ll receive a 1099 form from the bank showing you earned $5,000 in interest. If you’re in a 22% tax bracket, you’ll owe $1,100 in federal taxes on that interest. Additionally, that extra $5,000 of interest could push more of your Social Security income into the taxable range, costing you even more in taxes.

Now, imagine instead that you put the same $100,000 into a fixed annuity offering the same or higher interest rate. Because the interest grows tax-deferred, you won’t owe taxes on that $5,000 of interest until you actually withdraw the funds, which could be years later. This delay can reduce your current tax liability and help keep more of your Social Security income from being taxed.

Over the long term, the tax advantages of a fixed annuity could add up significantly. If you leave the interest to compound within the annuity, it could grow faster than in a taxable account like a CD, where you might have to use the interest earned each year to pay taxes.

Navigating the Interest Rate Landscape

One important consideration is the interest rate environment. The Federal Reserve has indicated that interest rates may drop in the near future. That means today’s attractive CD rates may not be available when your current CD matures. If you can lock in a higher interest rate with a fixed annuity for a longer period, it could be a smart financial move. Not only would you secure a higher rate for several years, but you’d also benefit from tax deferral.

High-Interest Debt: A Hidden Drain on Your Finances

Before committing to any investment strategy, it’s crucial to evaluate any high-interest debt you might be carrying. With interest rates rising in recent years, carrying debt like home equity loans (HELOCs), credit card balances, or car loans can become a significant financial burden. It wasn’t long ago that it made sense to keep low-interest debt while allowing your investments to grow. However, in today’s high-rate environment, it may be worth considering using investment funds or savings to pay off high-interest debt.

Eliminating these debt payments can free up more of your cash flow for savings and investments, helping you improve your financial outlook over the long term.

Crafting a Balanced Approach

As always, the key to successful financial planning is balance. CDs and fixed annuities are both excellent tools in today’s rate environment, but they serve different purposes within a retirement portfolio. CDs can be a good short-term vehicle for money you may need to access in the near future, while fixed annuities offer the benefits of longer-term growth and tax deferral.

By keeping an eye on your overall financial picture—especially any high-interest debt you may be carrying—you can make the most of these opportunities while securing your financial future. If you’re unsure which option is best for your situation, it’s always a good idea to consult with a financial planner to ensure your strategy aligns with your long-term goals.

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