In investing, one size does not fit all

Learn the difference between a CD and a tax-deferred annuity

Author: Dan Searles
Posted: Monday, December 01, 2008

We love those magazine ads selling shoes or leather jackets that say “one size fits all.” However, we are always very suspicious of them. Dan’s a pretty big guy, with 50-inch shoulders, who still plays rugby with “The Old Boys Club.” Tom is tall and a little on the thin side, due to either long hours of farm work or genes, we’re not sure.

The point is there’s no way the two of us can fit into the same of anything. Not a shoe, or a jacket or even the same sports car. Yet this is the type of thinking that Dan hears all the time in his practice. “My cousin got a stock market fund, so that’s what I’m going to buy as well.”

Or, “I’ve heard CDs are a bad place to put your money,” or, conversely, “I heard you should never buy a fixed annuity.” The truth is that fixed investments are like leather jackets. One size just does not “fit all.” That brings us to the question of the month.

Q: I am 62 years old and I have almost $100,000 to invest. I am very conservative and do not want my money in the stock market. These times are just too uncertain for me. Furthermore, I can live off my pensions, so other than an emergency, like a new car transmission, or if I need a nursing home, I probably won’t need this money. I’d really like it all to go to my kids. My banker suggested a CD; my insurance agent suggested a tax-deferred annuity. Who’s right?”

Dazed and Confused, Maryland

A: You state that you probably won’t need your $100,000 for the rest of your life, except in case of an emergency, like a transmission or if you need a nursing home. Otherwise, you want it all to go to your kids. We recommend that retirees keep three months’ worth of expenses liquid for emergencies, like that broken transmission or a leaky roof. So, calculate three months’ worth of bills and set that amount aside in a savings account. Just keep it in your bank. After you’ve done that, the remainder is eligible for long-term savings.

Now, let’s discuss the advantages and disadvantages of two popular long-term savings vehicles: a CD versus a tax-deferred fixed annuity:

A CD is not tax-deferred and a fixed annuity, as the name implies, is tax-deferred. Because the fixed annuity allows you to pay taxes only when you take withdrawals and not annually, it has the potential to build up cash at a much faster rate. (The reason this is true is that you always keep the interest on the tax-deferred.)

Generally, if you take one dollar out of a CD, you are likely to pay penalties on the whole deposit. Most fixed annuities allow up to 10 percent penalty-free withdrawals per year. If you name your kids as beneficiary on a fixed annuity, it can be structured to avoid probate.

Recently, some banks have added a POD (payable on death form) that, if structured correctly, avoids probate in some states, but each state is different and, in our experience, these forms are used only a small minority of the time.

Both the CD and the tax-deferred fixed annuity are free of market risk (i.e. the principals are guaranteed by the claims paying ability of the issuer). A CD is FDIC insured if you have under $100,000 in your account and offers a fixed rate of return. CDs and fixed annuities may not offer an equivalent degree of safety. Both investment vehicles are subject to inflation risk and interest rate risk.

Finally, the fixed annuity offers a new and important advantage. The federal government has recently passed a law which allows your children to inherit a fixed annuity. They can then take taxable small distributions over a number of years. This tax-deferred growth of the inherited fixed annuity (called a stretch provision) is more suited for investors who are unlikely to use the money during their lifetime for their own retirement needs.

If you missed last month's Money Matters column, read it here.

Do you have a question about your money? Send your questions to editor@excitingread.com.

Dan Searles, CFPâ, is a financial planner and a Registered Representative offering securities and advisory services through National Planning Corporation, member NASD/SIPC, and a Registered Investment Adviser. Tom Hardie, a lifetime investor, is a former U.S. government official and businessman, and now a full-time journalist and family counselor.

National Planning Corporation does not endorse the opinions expressed in this column. The information in this column is not to be considered as financial, tax or legal advice. As with any financial, tax or legal matter, consult your qualified securities, tax or legal advisor before taking action.

 

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