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How to Avoid Paying Unnecessary Taxes on CDs and Bonds

13th April 2010
By Robert Bell in Taxes
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CDs and bonds are generally seen as some of the most secure types of investments. Certificates of Deposits (CDs) are offered by banking institutions. They offer a set rate of return for an investment over a specific period of time. One of the disadvantages of traditional CDs is that you pay tax on the interest earned, even if you don't withdrawal any money from the investment. What this means is that even if you are benefitting from compound interest you are still paying unnecessary taxes if you aren't spending the money, because tax is being paid out of the investment. What you earn overall is reduced slightly each year relative to what you could earn in fixed annuity.

Is There a way to get More out of Your CDs and Bonds?

If you were able to get a tax deferral on your CD investment, you would be able to accrue more interest because your interest would be compounding on more money. You would still pay the tax when you withdraw your funds but in the interim, your investment would have grown at a much faster rate. Most people withdrawal money in retirement and since your tax bracket in retirement is usually less than when you are saving and working, this means that you are likely to pay a smaller percentage of tax if you cash in your investment after retirement.

Can you get a Tax Deferral on Bank-Issued CDs?

Unfortunately, there is little flexibility on bank issued certificates of deposit with respect to tax deferral. Short of trying to avoid the IRS, you cannot get away from paying annual taxes on a bank CD. You could, however, invest in a CD-type annuity investment that offers tax deferral benefits. The difference between a bank CD and a CD-type annuity is that the annuity is an investment policy issued by an insurance company as opposed to a bank. Some people say that insurance companies are not regulated in the same way banks are and that the investment is therefore riskier. However, you can obtain an industry rating on a particular insurance company which will give a good indication of their financial security and strength before placing your funds with them.

What are the Tax Benefits of Investing in a CD-Type Annuity?

The greatest benefit of a CD-type annuity is probably the tax deferral you get on the investment. With annuities, as long as the funds stay within the investment, you do not get taxed. It is only when you withdrawal funds from the investment that taxes are due. This means that you benefit from compound interest as your capital amount grows by the interest amount each year (pre tax) . For example, if you are earning five percent annual interest on an investment of $10,000, your investment will grow by $500 in the first year. In the second year, you will be earning interest on the amount of $10,500 which amounts to $525. Each year your capital amount grows and the interest amount therefore also grows accordingly. After five years, you will be earning more than $600 in interest a year on your investment because your investment capital amount is not being reduced by tax payments. You will only make one lump sum tax payment on your investment if you decide to liquidate the investment. If you do not liquidate the investment you can further delay paying the taxes.

What are the Other Benefits of Investing in CD-Type Annuities?

Because of the benefit of tax deferrals, it's quite obvious from the example above that an annuity investment grows at a far greater rate. As a result, it offers a better return on investment than a bank issued certificate of deposit. CD-type annuities are seen as some of the most secure types of investments.

In general, there is little difference in the security of a bank-issued CD and CD-type annuity investment. An annuity also offers a more flexible investment because of great withdrawal options. Most often, you can take out an annuity for a set term of either five or 10 years. The interest amount can either be set for the entire terms or for part of the term after which it reverts to a market-related percentage. Usually, there is a base limit meaning that the interest percentage you earn from your investment will never drop below a certain level. If you require funds, most policies will allow you to make withdrawals from the investment account up to a set percentage limit. In this way, CD-type annuities are more liquid and allow you access to your money if you need it. This can be especially useful if you have unexpected medical costs or a household emergency that you need to pay for.Annuity Rate was started to simplify the annuity buying process. Comparing between competing retirement income rates to help figure out which one is best suited for your needs. We also compare competing 401k rollover options rates to find the best deal for you. Visit us online today!
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