Fixed Annuities Versus Bonds: A Comparison for Retirement Income

You are likely seeing advertisements for fixed annuities offering 5 percent or more guaranteed interest. These pitches target safety-conscious investors who worry about outliving their savings in a volatile market.

However, bonds are also paying competitive yields right now for the first time in years. You must look past the marketing hype to see which investment actually puts more money in your pocket.

The choice between a fixed annuity and a bond portfolio affects your taxes, your liquidity, and what your heirs inherit. We will cut through the sales jargon with plain math to show you the real cost and benefits of each option.

Understanding Fixed Annuities

A fixed annuity is a contract between you and an insurance company. You give them a lump sum, and they promise a guaranteed interest rate for a specific period, similar to a certificate of deposit.

These are often called Multi-Year Guaranteed Annuities, or MYGAs. The interest grows tax-deferred until you withdraw it. However, your money is usually locked up for a period ranging from three to ten years.

If you need cash early, you will face steep surrender charges that can start at 10 percent or higher. Furthermore, while states have guaranty associations that cover failure, the protection varies by state and is not backed by the federal government like bank deposits.

The Mechanics of Bonds

Bonds are loans you make to governments or corporations. United States Treasury bonds are backed by the full faith and credit of the federal government, making them the safest investment for principal.

You can buy them directly from the Treasury at no cost through TreasuryDirect.gov. Corporate bonds pay higher yields but carry the risk that the issuer might default. Unlike annuities, bonds trade on an open market.

If interest rates rise, the market value of your bond drops. However, if you hold a bond to maturity, you get your full principal back provided the issuer does not default.

This distinction is crucial for anyone who does not want to lock their money away for a decade.

Comparing Yields and Taxes

You must compare after-tax returns to make a fair decision. Annuity earnings are taxed as ordinary income when you withdraw them. In contrast, interest from Treasury bonds is exempt from state and local income taxes, which can save you significant money depending on where you live.

If you live in a high-tax state like California or New York, a Treasury yielding 4.5 percent might beat an annuity yielding 5 percent. Municipal bonds offer tax-free interest at the federal level.

Investors in the 24 percent tax bracket or higher often find that a high-quality municipal bond paying 3.5 percent provides a better taxable-equivalent yield than a fully taxable corporate bond or annuity.

Liquidity and Access to Cash

Liquidity is often the deciding factor for retirees. Annuities generally restrict access to your funds during the surrender period. While many contracts allow you to withdraw up to 10 percent of your value annually without penalty, anything more triggers fees.

Additionally, if you take money out of an annuity before age 59 and a half, you face a 10 percent federal tax penalty on earnings. Bonds offer much greater flexibility. You can sell a Treasury bond on the secondary market at any time, or you can build a bond ladder where bonds mature at regular intervals to provide cash flow.

You do not need to ask an insurance company for permission to access your own money.

Costs and Commissions

Costs eat into your returns, and they are often hidden in annuity contracts. Insurance agents typically earn commissions of 4 percent to 8 percent on fixed annuities. The insurer recovers this cost by offering a slightly lower interest rate or imposing longer surrender periods.

When you buy individual bonds directly, you pay no commission. If you buy bond funds, you pay an annual expense ratio. A low-cost index bond fund might charge just 0.05 percent annually, whereas a managed annuity might effectively cost you 1 percent to 2 percent a year in lost returns.

Over 20 years, that difference amounts to thousands of dollars in lost compounding for you.

Inheritance and Estate Planning

You should consider what happens to your money when you die. If you own bonds, your heirs receive a step-up in basis. This means if the bonds have appreciated in value, the capital gains tax is wiped out at your death.

Annuities do not receive a step-up in basis. When your beneficiaries withdraw the money, they pay ordinary income tax on the earnings. Furthermore, annuities can go through probate unless you specifically name beneficiaries and understand the contract terms.

Bonds held in a brokerage account with transfer-on-death designations usually pass directly to heirs outside of probate, making the transfer faster and cheaper for your family.

Do not let a salesperson dazzle you with high guaranteed rates without reading the fine print. Fixed annuities have a place in a retirement portfolio for those who value guarantees over liquidity and do not mind locking up their money.

However, for many investors, a ladder of high-quality bonds offers better flexibility, lower costs, and favorable tax treatment. You must run the specific numbers for your tax bracket and state to see the truth.

Your goal is to maximize your safe income while keeping your hard-earned savings accessible. Always choose the option that serves your specific financial needs rather than the one that pays the highest commission to the broker.

Sources

• FINRA Investor Education Foundation, 'Annuities: A Closer Look,' (2023)
• U.S. Department of the Treasury, 'TreasuryDirect: Learn About Bonds,' (2024)
• Securities and Exchange Commission, 'Interest Rate Risk and Bonds,' (2022)
• Vanguard, 'The Case for Bond Funds in a Portfolio,' (2024)