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A Super Guide to Retirement CDs for the Beginner Investor

We’re all under pressure to save enough money for retirement. A million-dollar nest egg is now the baseline for what retirees need before they can stop working, but tens of millions of Americans, including many Millennials (those in their 20s and 30s), have fallen behind. An April 2016 study from robo-advisor Personal Capital found that 40% of young adults have yet to even begin stashing away cash to sustain them in their later years.

Making a commitment to set aside part of your paycheck for retirement is the first step towards a secure financial future. The next step is to decide where to put those dollars.

An important consideration for all investments is the level of risk they present. We’ll discuss risk levels associated with a few different types of retirement savings vehicles.

Many employers offer 401(k) accounts. They are powerful tools to jumpstart your savings, especially if your plan offers a matching contribution. Generally, 401(k) plans let you invest in mutual funds, which group together stocks, bonds and cash. While bonds are low-risk, stocks tend to be more volatile. A safe investment that carries less risk of loss tends to offer a lower rate of return over time. The variety of investments within a mutual fund is meant to balance out the level of risk the investor takes on, so that a portion of the money is sheltered in lower-risk investments.

How much of your money is sheltered depends on your personal preferences and the number of years you have to save. Historically, stock market investments earn more than bonds, but stocks come with a higher risk of losses in the short term. If you’ve got 30 or 40 years until retirement, most investment advisors will recommend that you put a larger portion of your savings toward higher risk investments where you stand to gain more. If you plan to retire within a few years, you might not have time to recover from unexpected losses, so your advisor will probably suggest that you keep more of your money safe in low risk savings vehicles.

An IRA (individual retirement account) is similar to a 401(k) but only people who work for a company that offers a 401(k) can contribute to a 401(k). Anyone under the age of 70 ½ and who has earned income can contribute to an IRA or Roth IRA. There are differences in how IRA accounts and 401(k) accounts are treated by the IRS, and how much you can contribute each year.

A CD is a low-risk savings vehicle, and a retirement CD is held within an IRA, along with whatever mix of stocks, bonds, mutual funds and other retirement investments you have chosen.

Retirement CD basics

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First, let’s break down what a retirement CD is. That begins with understanding how CDs and IRAs work.

What is a CD (certificate of deposit)?

A certificate of deposit is similar to a savings account, with a twist. When you have a savings account, you can deposit money whenever you like and make up to six withdrawals per month. When you have a CD, you deposit the money and the bank holds onto it for a term (a predetermined period of time), during which it earns interest. In most cases, you are subject to a penalty if you withdraw funds from a CD before its maturity date (the end of the term).

When the CD matures, you can cash out the money you originally deposited, along with the accrued interest, or you can roll the funds into a new CD. The interest you earned is reported as taxable income.

CDs tend to have more favorable interest rates than traditional savings accounts. CD terms can range from three months to five years, although they can be shorter or longer. The longer the term, the higher the interest rate usually is.

Compared to an investment in the stock market, CDs are about as safe as you can get. The biggest inherent risk is that you might need to access your money before the CD matures. If you cash out all or a portion of your CD before the maturity date, the bank may charge you a fee or withhold some of your earned interest.

What is an IRA (individual retirement account)?

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An IRA (individual retirement account) is a tax-advantaged savings account designed specifically for retirement. You can put money into an IRA to take advantage of the potential for growth along with certain tax advantages. The two most well-known types of IRA are traditional and Roth.

Traditional IRA

A traditional IRA allows you to contribute pre-tax money each year. That means you can deduct the amount of your contribution from your taxable income. When you withdraw the funds in retirement, you pay regular income taxes on it. If you are in a lower tax bracket in retirement than you are in now, you will save money.

The contribution limit is based on whether you have a retirement plan through your employer, how much money you earn and your age.

For example, in 2016 a single filer can contribute $5,500 to a traditional IRA ($6,500 if 50 or older). If the filer is covered by an employer’s plan and has a modified adjusted gross income (MAGI) of $61,000 or less, he can deduct the full contribution from his taxable income for the year. If the filer is NOT covered by an employer’s plan, he can deduct the full contribution regardless of income.

The money that you put into a traditional IRA grows tax-deferred. That means you don’t have to pay taxes on earnings until you take the money out in retirement.

You must be at least 59 ½ to withdraw money from a traditional IRA without a tax penalty. If you take money out before then, withdrawals are subject to a 10% penalty, along with regular income tax.

Once you turn 70 ½, you must begin to take required minimum distributions (RMDs) from a traditional IRA. The amount you’re required to withdraw is based on your life expectancy and the amount you have invested. If you don’t take the RMD on schedule, the IRS can hit you with a tax penalty equal to 50% of the required withdrawal amount.

Roth IRA

Instead of getting a tax break upfront in the form of a deductible contribution, Roth IRAs offer you a tax benefit when you withdraw the money. Qualified withdrawals made after age 59 ½ are 100% tax- and penalty-free.

You can pull your original contributions out of a Roth IRA at any time without a tax penalty if you’ve owned the account for five years or longer. Under certain circumstances, you can also withdraw earnings tax- and penalty-free before age 59 ½. For example, you can withdraw up to $10,000 towards the purchase of a first home.

Your income determines whether you can contribute to a Roth IRA. For 2016, a single filer can max out a Roth IRA if her MAGI is less than $117,000. The contribution limit phases out for individuals earning $118,000 to $132,000. Married couples filing jointly can contribute the full amount if their combined income is less than $184,000.

Both Roth and traditional IRAs have the same annual contribution limit. As of 2016, the limit is $5,500, and $6,500 for savers who are 50 or older. The same limits will be in effect for 2017.

What is a Retirement CD?

A retirement CD is a certificate of deposit that you own inside an IRA. The various tax benefits associated with the traditional or Roth IRA also apply to the CD, as do the IRA contribution limits.

Individual retirement CD terms, such as the minimum required deposit, interest rate, and term length vary widely from one bank to another.

You may have some flexibility when it comes to how you earn interest on an IRA CD. For instance, the bank may offer retirement CDs with a fixed rate or a stepped rate. On a stepped-rate IRA CD, the interest rate periodically increases over the CD term.

Unlike other types of investments whose rates of returns can fluctuate, CDs come with a specified rate. How much you earn towards your retirement nest egg depends on the amount you invest and the CD’s annual percentage yield (APY).

For example, on a 24-month, 1.5% APY IRA CD with a $5,000 initial deposit, you’ll earn about $152.  The best CD rates are currently around 2% for a 5-year term, but not all offerings are retirement account eligible. As of late November, 2016, Everbank offers a 2.05% CD that is IRA eligible with a $5,000 minimum deposit.

Pros and cons of using an IRA CD to save for retirement

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As with any investment, you need to carefully weigh the positives and the negatives before you plunk down your cash.

IRA CD pros

  • Safe: An IRA CD is a safe investment. You don’t have to worry that a market downswing could wipe out your savings. Be sure you buy the CD from an FDIC or NCUA insured institution (like a bank or credit union).
  • Predictable: When you invest in an IRA CD, you know upfront how much interest you will earn and can predict what the value of the investment will be once the CD matures. With stocks or mutual funds, there’s no way to tell with exact certainty how much of a return your investments will generate.
  • User-friendly: You may be able to open an IRA CD directly through the brokerage firm that handles your IRA. (If you open the CD separately, you will need to initiate a non-trustee-to-trustee transfer if you want to put the CD into your IRA.) After you choose the CD you like, you simply open the account and wait for it to mature.
  • Minimal fees: Depending on the bank you choose, the only fee you may ever have to pay is the penalty fee for tapping a CD early.
  • FDIC / NCUA coverage: Deposit accounts at insured institutions are protected by the FDIC (NCUA if the institution is a credit union) for up to $250,000 per account. If your bank fails, you can still get your money back. Mutual funds and stocks aren’t afforded that protection.
  • Tax advantages: Investments held in IRAs can provide tax advantages now or later. Interest earned on a CD held outside your IRA is subject to regular income taxes.

IRA CD cons

  • Performance: Compared to other investments, IRA CDs don’t have the potential for large returns. Over the long term, a well-balanced stock portfolio might net more gains.
  • Low liquidity: Once you put money into a CD, the money is inaccessible until the CD matures.

Tips for choosing a retirement CD

Here are a few pointers to help you choose the right retirement CD.

  • Compare rates: Take the time to scout out the best deal. Don’t forget to consider brokerages and online banks, which may offer more in interest than brick and mortar banks.
  • Review the fees: Ask whether the bank charges a monthly or annual maintenance fee for retirement CDs. Understand the penalty fee so you know what you’ll have to fork over if you withdraw funds before the CD matures.
  • Consider the minimum investment: Larger deposits usually mean better returns, but you’ll need to weigh the potential interest earnings against the possibility that you’ll want access to the cash before the CD matures.
  • Check the maturity terms: Longer terms usually mean better returns, but shorter terms mean you’ll regain access to your money sooner. Be sure to ask whether the institution will automatically reinvest your funds in a new CD or return the money to you.

 Retirement CD ladder

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A CD ladder means opening multiple CDs with staggered terms, usually one to five years. As each CD matures, you reinvest the money in a new five-year CD. Ultimately, you’ll have all of your money in five-year CDs for the higher rate, but access to a portion of your money each year as an account matures.

 

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Published December 8, 2016
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