When you invest money for retirement, it should generate more money for you later, when you are done working. Buying a certificate of deposit, also known as a "CD," might be a good choice if you need a specific amount of money to become available at a certain future time, with no risk of losing all of your cash. That time should be not too far off rather than years down the road.
If you are investing for a retirement that is still many years away, CDs might not be the best choice, because you run the risk of losing money in the long run due to inflation and taxes.
Learn more about when and why CDs are a good investment choice and when and why they are not.
Key Takeaways
- A CD might be a good investment choice if you need a specific amount of money to become available at a certain future time with no risk of losing all of your cash.
- The rate of interest on CDs is often less than the rate of inflation. When combined with taxes on the interest, you can lose money over time.
- In general, CDs are a good investment if you are in a low tax bracket, want no investment risk, and want to preserve capital.
- Anyone who needs ready access to their cash would be a poor candidate for long-term CDs.
Risk of Loss With CDs
It is possible to lose money even on a safe retirement investment like a CD, which, like other kinds of bank deposits, is guaranteed by the Federal Deposit Insurance Corporation (FDIC).
The rate of interest on CDs is often less than the rate of inflation. When combined with federal and state income taxes on the interest, you can lose money over time in investments like CDs that appear to be safe and secure. For example, suppose you are considering a $10,000 CD that would mature in five years. It pays 3% per year in interest, so it would produce an additional $300 per year.
If you pay taxes at a 25% federal rate and a 5% state rate, you'd owe $90 in taxes on the CD interest just in the first year.
If inflation is 3% per year, at the end of the year, you would require $309 to buy $300 of goods and services. After taxes, your CD would have delivered just $210.
Planning for Retirement With CDs
If you take the time to design a retirement plan, you should know what minimum rate of return you'll need over the years if you're going to achieve your retirement goals.
If you need only a 4% rate of return to meet your retirement goals, and you can find a CD that pays 4% or more, a CD might be a good choice for you.
In this case, you might be able to create a CD ladder through which your CDs mature on different dates leading up to your target retirement date. Doing so can help you hedge against a decrease in interest rates. If the CDs don't achieve the rate of return you need to achieve your goals, you will still have a few possible solutions.
You can reinvest in other retirement vehiclesas each CD expires, ones that might achieve a higher rate of return. Alternatively, you might decide to work longer or find a way to reduce living expenses so you can achieve your goals on the returns offered by your CDs.
Note
CD rates are always changing. As interest rates and your goals change, you can mix up your investment choices to keep pace.
Who Are the Best Candidates for CDs?
In general, CDs are a good investment if you are in a low tax bracket, want no investment risk, have a primary goal of preservation of capital (rather than growing capital), and plan to use the funds at a time that matches the CD maturity date.
It is also important to know whether you can lock in a rate of return higher than the rate of inflation over the time period you need. For example, if you arein a low tax bracket and don’t need the funds for 10 years, a 10-year CD that pays 5% would be a good investment if you expect inflation to be 3% or less.
Note
If you arein a higher tax bracket, you might consider a tax-deferred or tax-free alternative to CDs, such as Series I savings bonds, fixed annuities, ultrashort-term bonds or bond funds, or short-term municipal bonds or bond funds.
Who Are the Worst Candidates for CDs?
CDs are likely a poor choice if you believe you would be losing money after you factor in taxes and inflation, have a primary investment goal of growth or steady income, or need to be able to withdraw your money at any time.
CDs are not a liquid investment. You can't withdraw your cash early without incurring penalties. Anyone who needs ready access to their cash would be a poor candidate for long-term CDs.
Using CDs in Retirement
While CDs may not be a good investment for a retirement that is still several decades away, they could be a useful tool once you are already retired or close to retirement age.
Storing money that you don't need immediately in a CD allows you to continue earning interest, which can increase the amount available to you during retirement. The shorter investment timeline means that the interest on your CD is more likely to be able to outpace the rate of inflation.
Other investments that you can use to help your money grow in retirement include high-yield savings accounts, interest-bearing checking accounts, and money market accounts.
As always, when planning for retirement or managing your money while retired, it is helpful to hire a financial advisor who will understand your particular financial circ*mstances.
Frequently Asked Questions (FAQs)
What kind of CDs are available for retirement?
There are multiple types of CDs and strategies you can integrate into your retirement horizon. Terms for most bank-issued CDs range from a few months to as long as five years. Interest rates on CDs tend to be lower than returns on many mutual funds and stocks, but you can typically boost your APY by looking for promotional CD rates.
What are IRA CDs?
An IRA CD is a certificate of deposit that's held in an individual retirement account (IRA). Like regular CDs, IRA CDs mature after a certain period of time and pay a fixed interest rate. You may face IRA-based early withdrawal penalties if you withdraw your IRA CD money before age 59 1/2.
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Certificate of Deposit (CD): A Certificate of Deposit, or CD, is a financial product offered by banks where you deposit a specific amount of money for a predetermined period, and in return, you receive a fixed interest rate. CDs are considered low-risk investments, and the principal amount is typically guaranteed by the Federal Deposit Insurance Corporation (FDIC).
Inflation and Taxes: The article emphasizes the impact of inflation and taxes on CD investments. The rate of interest on CDs is often lower than the rate of inflation. When combined with taxes on the interest earned, investors can experience a loss of purchasing power over time. This is due to the fact that the real value of the returns may not keep up with the rising cost of goods and services.
CDs and Retirement Planning: CDs can be a suitable option in retirement planning, particularly if you have a specific financial goal with a known future date. The article suggests that if you only need a modest rate of return to meet your retirement goals, and you can find a CD offering that rate, it might be a good choice. Creating a CD ladder, where CDs mature on different dates leading up to your retirement, can help manage interest rate fluctuations.
Best Candidates for CDs: The article outlines characteristics of individuals who might be good candidates for CDs. Those in a low tax bracket, seeking no investment risk, prioritizing capital preservation over growth, and planning to use funds at the CD maturity date are considered suitable candidates for CDs. Additionally, it's important to lock in a rate of return higher than the expected rate of inflation over the chosen time period.
Worst Candidates for CDs: Conversely, CDs may not be suitable for individuals with a higher tax bracket, those anticipating losses due to taxes and inflation, or those with investment goals focused on growth or steady income. CDs are considered illiquid, making them inappropriate for those needing ready access to their cash.
Using CDs in Retirement: While CDs might not be ideal for long-term retirement planning due to inflation concerns, they can serve as a useful tool for individuals already retired or close to retirement. Storing money not immediately needed in a CD allows for continued interest earnings, potentially outpacing inflation over a shorter investment timeline.
FAQs - IRA CDs: The article touches upon Individual Retirement Account (IRA) CDs, which are essentially CDs held within an IRA. Similar to regular CDs, they mature after a specified period and pay a fixed interest rate. However, early withdrawal penalties may apply if funds are withdrawn before the age of 59 1/2.
In conclusion, the article provides a comprehensive overview of the considerations associated with investing in CDs for retirement, shedding light on the factors that make individuals suitable or unsuitable candidates for this investment option.
