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March 2002

Q. What is a CD? What issues should I consider before investing in one?

A. A CD is a Certificate of Deposit that is issued by banks, savings and loans institutions, and some credit unions. Sometimes, you can open a CD with a small minimum investment, such as $100. Your money remains in the CD for a set period of time--anywhere from 6 months to 10 years, depending on the CD. CDs pay a fixed interest rate, and interest is usually compounded daily. The interest earned within a CD is taxable each year, even if the money is not withdrawn from the CD. (However, for CDs purchased within IRA accounts, any applicable taxes come into play upon withdrawal of the funds, rather than as they accumulate.) Normally, penalties equal to six months of interest apply if you want to withdraw your money early. However, some banks offer CDs that allow one withdrawal over the term of the CD without a penalty. The allowed withdrawal may be a portion of the total balance, or it can be the entire balance. A CD will usually offer a better interest rate than a standard savings account, and it is insured by the federal government. For example, if the CD is with a bank, the FDIC insures up to $100,000 per account.

The main reason people purchase CDs is safety. Unless they are market-adjusted CDs, the federal government insures them, they provide a guaranteed rate of return, and they guarantee the return of the principal. Of course, the tradeoff for this security is a relatively low rate of return.* Since rates are low and are likely to stay low for the short term, it would be prudent not to tie your money up in a CD for more than 18 months at a time, unless it's a penalty-free CD. A longer term CD could be beneficial depending on the rate of return and your particular financial situation. A qualified advisor can determine if any CD is an appropriate investment for you.

You may choose to purchase a CD with IRA funds. If you do, the IRA rules apply. For instance, if you purchase a CD with funds inside of a traditional IRA, the money cannot be withdrawn from the IRA until age 59-1/2 without penalties, or under special circumstances. So, once the CD matures, the money must be reinvested in another CD or other investment vehicle (stocks, mutual funds, annuities, etc.), as long as it stays in the IRA. Later, when you withdraw money from the IRA, taxes will be due on both the money earned and the money invested. In the case of a Roth IRA, you pay taxes on your money before investing it, so taxes will be due only on the interest earned. The Roth IRA rules also provide for earlier withdrawal, so the money could be withdrawn after five years. Of course, if the CD matures before then, the money would need to be reinvested within the IRA in order to avoid penalties.

Three factors might lead you to consider investing in a CD:

  1. You have a low risk tolerance (unless you are considering a market-adjusted CD).
  2. You have extra cash (such as a tax refund) that you don't need to access right away.
  3. You'd like an insured savings vehicle that may yield a better return than a traditional savings account or a money market fund.

The fees to open a CD are generally nominal or nonexistent. When choosing a CD, however, be sure to do your homework.

  • Make sure the institution offering the CD is stable and solvent. Its annual report, showing assets and liabilities should be available to the public. Of course, your risk is reduced because the CD should be insured through the FDIC or other Federal agency.

  • Shop around and compare rates. The Internet is a good place to do that.

  • Read the fine print. It never hurts to review the CD terms with your financial advisor.

*Beware of one type of CD, called a Market Value or market-adjusted CD. This type has longer terms than standard CDs, and it can assess large penalties on investors who want to make early withdrawals. In the case of an early withdrawal, the rate of return could change and the return of the principal is not guaranteed. Check with your financial advisor before investing in this type of CD.

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