Key takeaways
- CDs pay more than savings accounts, but usually less than the stock market over the long term. They’re typically a good match for conservative savers with medium-term money goals.
- Once you open a CD, you won’t be able to access the principal until the end of the term without facing penalties. Terms can last anywhere from three months to 10 years.
- Earnings on CDs are taxable as income. You can shelter your interest from taxes by setting up a CD ladder within a Roth IRA.
CDs are one of the safest places to keep your money, with government-backed insurance virtually guaranteeing you will get your money back with interest. While interest rates are usually much less than you get from the stock market, the safety of CDs make them a good fit for many people’s financial plans. Once you have an understanding of how they work, you can evaluate whether they’re a good match for your personal financial goals.
How CD accounts work
CDs are FDIC-insured savings products. When opening a CD, you’ll take a lump sum and lock it into the account for a set term – usually with a fixed interest rate. This interest rate is typically noticeably higher than anything you’d find offered for a standard savings account. If you withdraw your money prior to the term’s end, however, you’ll end up owing early withdrawal fees.
Say you wanted to open up a three-year CD. One of the best rates for this term at this moment is 3.25% APY
You should plan on your $1,000 staying in the CD for the full term, which in this case would be three years. If you take the money out within the first year, PenFed would take all the interest you had earned before giving you back your $1,000. After the first year, they’d take 30% of the total interest for the entire three-year term. These penalties change depending on your financial institution.
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How IRA CDs work
The interest on CDs is taxable income. Some savers can save on taxes by opening the account as an IRA CD – or a Individual Retirement Account Certificate of Deposit. The tax rules of IRA then apply, meaning you don’t have to pay annual taxes like a typical CD or savings account.
With a Traditional IRA, the money you put into your CD is tax-deductible in the year of your contributions. But when you withdraw from your IRA in retirement, the withdrawals are taxed at your regular income tax rate, which is likely lower when you’re no longer going to work full-time.
If you have a Roth IRA CD, the money you put into your IRA CD will still count as taxable income in the year of your contributions – it won’t be deductible. But when you make withdrawals in retirement, you won’t have to pay any taxes on them. This strategy helps you avoid paying any income or capital gains taxes on interest your CD earns.
The IRA has tax favorable aspects but keep in mind, this is a tool aimed at saving money for retirement. You will normally not have access to these funds without paying taxes and penalties until you reach a government-mandated age for these accounts.
CDs have less risk
CDs are an extremely low-risk product to hold in your portfolio. They might earn you a higher interest rate than a savings account, but they’re highly unlikely to earn as much as an index fund over a period of decades.
The reason the earning potential is lower is that they’re inherently less risky. There are circ*mstances where an early withdrawal penalty could cut into your principal investment, but it’s extremely rare. As long as your CD is held with an FDIC-insured institution, it’s insured up to $250,000 per depositor. That means joint accounts may qualify for up to $500,000 in government-backed insurance.
There is also no market risk with a CD. The stock and bond markets could go down, and it doesn’t affect your CD. You’ll know exactly how much money you have put in and how much interest you’ll earn when your CD matures. You know this from day one and see it work through your regular account statements until maturity.
CD ladder
A CD ladder helps you diversify your CD portfolio to help you manage interest rates and avoid locking money away for too long. For example, rather than open a $50,000 CD with a five year term, you might pick five CDs for $10,000 each. You could have one mature in one year, two years, and so on.
This strategy gives you periodic access to funds without paying any early withdrawal penalties. Interest rates likely vary by term, and you won’t earn as much on shorter term CDs in most cases. However, the rolling maturity dates offer several benefits.
Ideally, you’ll reinvest your earnings into even more CDs to keep your savings growing, but it provides you the option for some shorter-term liquidity. If you need to tap into a portion of your savings, you’d have the option to access it penalty-free in just one year rather than waiting five years or break the entire CD.
Stocks offer a better rate of return (usually)
If you’re investing long-term, stocks are likely to offer a dramatically higher rate of return. While CDs are currently paying above 3% in a high-interest environment, the historic annualized average return of the S&P 500 is 11.88%.
Because that number is average and annualized, it does not mean you’ll earn 11.88% every year. Some years you may earn much more. In other years, you’re likely to lose money.
But if you’re using a buy-and-hold strategy over a long period of time, these average annualized returns are what you want to consider rather than how much you ‘make’ or ‘lose’ in any given year. CDs may be a safer “investment,” but they’re also likely to earn less.
Consider your goals and weigh accordingly
How you save or invest your money is going to be entirely tied to your personalized goals. If you’re in your twenties and are only interested in saving for retirement, you’ll probably want to consider stocks more heavily than CDs.
If you’re approaching retirement and can’t bear to lose any money, a CD becomes more appealing.
If you don’t feel completely comfortable evaluating your own risk tolerance, you can have AI do it for you. Q.ai’s Investment Kits build and maintain a portfolio for you, taking into account your time horizon, financial goals, and marketplace data.
Using a CD outside of an IRA can help you meet your medium-term financial goals without the short-term risk of the stock market. You might build a CD ladder to store your savings for a home down payment, an auto loan down payment, the anticipated birth of a child, or some other life milestone at a potentially higher rate than if you kept the money in a savings account.
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