The Pros And Cons Of IRA CDs
An individual retirement account (IRA) is a great way to supplement your retirement savings. An IRA gives you valuable tax advantages when you invest in securities like stocks, bonds and mutual funds—and it’s not tethered to an employer, like other retirement plans. You might not know it, but you can also invest IRA funds in certificates of deposit (CDs).
An IRA CD is an individual retirement account that holds certificates of deposit. Everyone from financial behemoths like Fidelity and Vanguard to your local bank or credit union offers IRA CDs. Let’s take a look at the pros and cons of investing IRA retirement funds in CDs.
How Do IRA CDs Work?
When you deposit money in a certificate of deposit, you’re agreeing to leave it alone for a set term, often ranging from six months to five years, depending on your certificate of choice. In exchange, you get a guaranteed rate of interest over the life of your certificate.
Think of an IRA as a container that holds investments for retirement. You deposit money in the IRA container, and then invest the funds in stocks and bonds—or CDs. Whichever you choose, the advantage is that the IRA container means you never have to pay capital gains taxes on your investment gains. With an IRA, you either pay income taxes on money before depositing it in the account today or when you take withdraws in retirement.
An IRA CD is nothing more than an IRA where you invest your retirement funds in CDs. Some people choose to invest a portion of their retirement savings in a low-risk IRA CD to help diversify their retirement portfolio and provide stable, dependable income.
IRA CDs could be a smart addition to your retirement planning strategy, but in today’s near-zero interest rate environment, they have significant downsides you need to understand. We asked financial experts for their take on the pros and cons of IRA CDs—here’s what they had to say.
Pros of an IRA CD
The biggest advantages of IRA CDs are low risk and flexibility for delivering short-term cash flow when you need it most, just before and just after retirement.
IRA CDs Are a Safe, Low-Risk Investment
In exchange for locking up your money for a set term, an IRA CD provides a guaranteed return on your investment. When you invest in CDs backed by a Federal Deposit Insurance Corp. (FDIC) member institution, like a credit union or a bank, your principal is insured up to $250,000 per depositor, for each account, in the event of a bank failure.
“We’re holding CDs in lieu of bond funds in clients’ IRAs, especially those who are older than 59 1/2 who want security for at least a portion of their portfolios with basically no fee,” says Dennis Nolte, a financial planner in Oviedo, FL.
IRA CDs Can Fill Short-Term Income Needs
If you’re getting close to retirement or you’ve just retired, you need a more conservative mix of investments to generate immediate retirement income. Sequence of return risk could be your greatest enemy, and CDs are a solid portfolio option to help fend off this risk and generate near-term income from your nest egg.
“The good thing about using CDs in an IRA is the ability to create a ladder for predictable income in the short term,” says Kristin Sullivan, a financial planner in Denver, CO. “However, most IRA money should still be positioned for longer-term growth.”
Even if you are already retired, keep in mind that you should still be invested in a diversified mix of assets, depending on your overall investment goals and strategy. And be careful not to over-invest in CDs, since their current low yields might not keep up with inflation.
Cons of an IRA CD
The biggest downside of certificates of deposit—and it’s a biggie right now—are their ultra-low yields. But there are a few other pitfalls to keep in mind as well.
CDs Are Paying Near-Zero Returns
As of March 15, 2021, the current national average rate on a 12-month CD was only 0.14%, according to the FDIC. Even the best CD rates from online banks are in the range of 0.55% to 0.75% for a 12-month certificate. Such low rates of return might not be worth a second look for your retirement strategy, unless you have substantial assets and an exceptionally conservative risk tolerance.
“No matter the environment, interest rates on CDs are always only a small percentage higher than the prevailing rate of inflation,” says Mychal Eagleson, a financial planner in Indianapolis, IN. “So, in terms of real returns—return minus inflation—their yield is always relatively low.”
IRA CDs Take Up Valuable IRA Space
Annual IRA contributions are capped at just $6,000, or $7,000 if you’re 50 or older.
“Using up that limit contributing to a low-return investment like an IRA CD detracts from the dollars that can be invested in stocks and even bonds, which over the long term have provided higher real returns,” says Eagleson.
IRA CDs May Be Too Conservative
IRA CDs may not be the best fit for your investment time horizon. Investing money in CDs isn’t going to get you much bang for your retirement buck.
“It’s best to get as much growth as possible in an IRA,” says Artie Green, a financial planner in Los Altos, CA. “If the IRA owner is young, it makes the most sense to invest in higher-yielding assets.”
If your target retirement date is still several years or a few decades away, you will likely be better off investing your IRA money in assets like stocks, bonds or mutual funds that have greater potential for long-term growth—unless you have substantial assets or an exceptionally low risk tolerance.
With a CD, You’re Locked In
The safety and fixed-rate return of a CD comes at a price—you generally can’t access your money before the CD term is up without paying a penalty for early withdrawal penalty. If interest rates go up during the term of your CD, you’re still locked into your initial rate.
The Federal Reserve has indicated that current near-zero interest rates might continue through 2023, but what if interest rates go up significantly in the future, and you’re still stuck with a lower-yielding CD?
There Are More Flexible Options
Do you want low-risk investments that pay a stable yield and generate immediate retirement income? There are other ways to achieve those goals without the limitations of IRA CDs.
“The only possible use of an IRA CD would be for money you know you will need to withdraw in the next 12 to 24 months,” says Chris Baker, a financial planner in Carmel, IN. “But that same objective can be obtained by utilizing short term bonds, and you don’t have the restrictions of a CD with a three, six or 12-month term.”
When Should You Consider an IRA CD?
If you’re on the cusp of retirement or already needing to earn income from your retirement savings, and you want FDIC-insured safety for a portion of your retirement investments and are willing to accept a low but stable yield, then IRA CDs can be a worthwhile addition to your portfolio.
However, IRA CDs feature significant limitations. Be careful about inflation risks, interest rate trends and think carefully about how IRA CDs fit into your overall investment strategy. As a general rule, CDs are often a better investment for short-term goals, for example, if you need to keep your savings safe for a year or two, while earning some interest along the way.
But if you need longer-term growth, or want short-term investments that pay a stable yield at low risk, there are other investments that might be a better fit for your goals.