Tri-State Neighbor: South Dakota Farm Newspaper

Dear Michael: It seems like everywhere we turn these days, we hear conflicting accounts on which is the better choice among annuities, mutual funds and CDs. Different agencies give us different viewpoints on which way to go. How do I sort out what is the right thing for me? - Financially Torn.

Dear Torn: Your experience with all of these different purveyors of financial products is pretty common. Right now, executives from each industry - banking, brokerages and insurance companies - are planning how to capture a part of the incredible, cumulative wealth of the “baby boomers” now reaching age 65. Unfortunately for you, Torn, this sometimes leads to a lot of mudslinging rather than an explanation of the facts as they are and you're getting caught in the backwash.

Understand that all of these financial instruments are just that - instruments. They are like tools in the shed and depending on what goal you'd like to accomplish determines what tool you pull off the rack to complete the job. There are no “bad” financial instruments - just like there are no “bad” pliers or “bad” saws in your shed - just different tools for different jobs.

To differentiate which is which, let's make a simple assumption. Let's say you want to put $100 per year into an investment. Where do you put your $100 of hard-earned money?

If security, liquidity and easy access are high priorities for you and you don't want to risk losing any of your $100, the easy choice would be a CD or a similar alternative. Guaranteed by FDIC, CDs are easy access and you only risk loss on interest earnings if you withdraw early.

The bank is going to use your money to borrow out, and rates on CDs are going to be below whatever the loan rate is. That's how they make a profit. The recent attempts over the past eight years to jumpstart the economy by suddenly lowering loan rates has adversely affected any savers using bank instruments. Interest earned is taxed as ordinary income on your income taxes. CDs and other banking instruments have been around, in some form, since early Egyptian times.

Let's say you feel like you have some income tax issues and would prefer to defer the taxation of your interest. You still want to have safety and security with a guaranteed rate of return.

Your alternative would logically be to use a fixed annuity - which has been around in some form since Roman times. An annuity is backed by the financial strength of the insurance company.

Some annuities have guaranteed fixed rates of return while others use different crediting methods for determining how interest will be paid. An annuity's interest return is taxed upon withdrawal as ordinary income.

Annuities have surrender charges for one year to as much as 20 years depending on what type of a contract you enter into with the company. These charges are necessary because of the reserving required by federal law. Because companies use long-term government bonds to guarantee the safety of your principal in the future, the government bonds, if cashed in early, won't yield the total amount needed. The bond hasn't matured yet and, hence, you have a surrender charge.

A short-term commitment of your money means the company will use short-term bonds with low rates and short surrender charges. The longer time you commit, the higher rate long-term government bonds used, and the higher return paid to you. However, the longer term means longer surrender charges. Simple, yes?

Let's say you feel adventurous with your money and say you hope to get a better rate of return than either bank or insurance company savings instruments and you are willing to take some risk with both your principal and your interest - meaning you might lose some money or you might gain some money. You would then buy individual stocks, bonds or mutual funds.

Unlike CDs or annuities, there is an up-front sales fee paid on the purchase of these investments and, typically, an ongoing management fee deducted and paid to the broker/dealer. These investments pay interest in the case of bonds, or dividends for stock and mutual funds and these sums are taxable each year.

Now, if your choice of stocks or funds is attractive to other buyers and you can sell your investment for more than you paid for it originally, you made more money. This “gain” in value is then a capital gains tax - not ordinary income.

As we go through life our savings habits change, our risk mentality changes and the long- and short-term goals for our money change. Based on where you are in life helps you decide where you may want to portion your money.

For now, though, let's just end with there are no truly “bad” investments. There are only different financial tools in the shed. If someone tells you an instrument is a “bad” investment, he or she is truly uneducated on the history, development or uses of different financial instruments.

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