Certificates of deposit, or CDs for short, are savings vehicles often touted as smart investments for anybody’s financial portfolio — and for good reason.
CDs are a safe place to store cash and offer a guaranteed interest rate. In fact, the highest CD rates can help you beat inflation and reach your savings goals faster. That’s why they make an excellent addition to your retirement savings plan.
How do CDs work?
CDs are considered a time deposit account, meaning you deposit a lump sum amount and keep it on deposit for a certain period, known as the term. CD terms can range from a few months to several years. During this time, you’ll earn a fixed interest rate (your exact rate depends on the particular financial institution and term length selected). Some of the best CD rates rival those offered by high-yield savings accounts and money market accounts.
Once you reach the maturity date, you can access your money, plus the interest you have earned.
Technically, you can access your money before the CD matures, but you’ll be subject to an early withdrawal penalty. If you think this will be an issue, you could consider a no-penalty CD. However, not all banks offer these, and you’ll likely earn a lower rate than you would with a traditional CD.
How a CD can help you reach your retirement savings goals
Investing is inherently risky, but CDs are not. That’s why they’re important to a retirement savings plan.
The general consensus among retirement planners is that everybody needs to take some calculated risks when investing. You might think the safest approach to investing is to put all of your money in a savings account, where you’ll earn interest and can’t lose your money. The problem, however, is that most people won’t earn enough interest to fund their retirement.
So retirement planners suggest an asset allocation strategy where you have a mix of investments of varying risk — such as stocks, mutual funds, and exchange-traded funds — as well as low-risk investments and accounts such as bonds and CDs.
There are even CDs designed specifically for retirement savings, known as IRA CDs or retirement CDs.
An IRA CD is a hybrid of an individual retirement account and a certificate of deposit, which combines the tax benefits of a retirement account with the security of a CD. With an IRA CD, your money goes into an IRA that only invests in CDs. Sometimes, the interest rates with an IRA CD are higher than a regular CD, though not always. As with any investment, you’ll want to do your research beforehand and make sure this type of account fits your retirement savings goals.
Pros and cons of a CD for retirement savings
Naturally, as with all investments, there are some pros and cons to putting money in a CD.
Pros
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Encourages long-term savings: Unlike a savings account, where you can pull the money out at any time, you’re supposed to keep the money in there until the CD matures. So if you’re serious about putting some money away and not touching it, a CD could help.
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High interest rates: Many CDs offer higher interest rates than traditional savings accounts. Still, high-yield savings accounts are often competitive with CDs, so you’ll want to take a look at both.
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Guaranteed, predictable income: This is a big selling point of a certificate of deposit. You’ll know exactly how much your money will grow over the term, and the account can’t lose value (unless you incur fees).
Cons
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Lack of flexibility: When you put money into a CD, you shouldn’t raid those funds until the term is up. That may be a challenge if you think you’ll need to access your funds sooner.
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Low interest rates compared to other investments: Yes, you’ll probably earn more than you will with a savings account, but investing in market securities will take your money a lot further.
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Interest is taxable. If you earn interest over $10, it’s treated as ordinary income, and you’ll pay tax on it. You may be interested in other types of investments with more tax advantages, such as Treasury bills.
The fact that you can lock in your interest rate with a CD is both a pro and a con, depending on the circumstances. When interest rates are climbing, money tied up in a CD at a lower interest rate will miss out on those higher returns.
On the other hand, if you lock in a competitive CD rate and then interest rates fall, you’ll be at an advantage for the length of the CD’s term.
How to create a CD ladder for retirement income
A CD ladder is a savings strategy devised to minimize some of the shortcomings of a CD. For instance, let’s say that you have $5,000 that you want to put into a CD. You like the idea of guaranteed income, and you’re thinking of putting the $5,000 into a five-year CD.
But you may wonder if you’ll need the money sooner than five years. You may also be concerned that interest rates could increase within those next five years. While you could always select a shorter-term CD, you may regret it if rates actually fall.
A CD ladder can help hedge your bets.
For instance, instead of depositing $5,000 in one CD, you could spread the money across five CDs and stagger the maturity dates. You could put $1,000 into a one-year CD, and another $1,000 into a two-year CD, and so on, spacing them out over five years.
Whenever one of your CDs matures, you can either reinvest that $1,000 into a new CD and keep the ladder going, or keep the money to use for something else.
Does a CD belong in your retirement savings plan?
Few, if any, retirement planners would ever suggest you only invest in CDs — or in any one investment vehicle. A healthy retirement portfolio will have a mix of investments with varying risk.
But the appeal of a certificate of deposit is in its lack of risk, which is why it can be a good bet for people near the end of their money-making careers. Because CDs offer guaranteed interest income over a certain period of time, you could argue that it’s risky not to invest in one.
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