Q. What is a CD? What issues should I consider before investing in
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within a CD is taxable each year, even if the money is not withdrawn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a traditional IRA, the money cannot be withdrawn from the IRA until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:
- You have a low risk tolerance (unless you are considering a
- You have extra cash (such as a tax refund) that you don't need to
access right away.
- 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
- 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.