In the early part of this century – which really wasn't that long ago – you could buy a certificate of deposit that would pay more than 7 percent interest every year for five years. But as the century entered its second decade, it was difficult to find even a 2 percent return. Although there's safety in CDs, there also are challenges in deciding on your strategy, no matter if your CD lies in or out of an individual retirement arrangement.
When you buy a certificate of deposit, you invest a fixed sum of money for a specified period -- anywhere from seven days to five years or more. In return, you get paid interest at designated intervals. CDs are issued by financial institutions, mainly banks, credit unions and thrifts, which primarily are savings and loan associations. Unlike other investments, CDs come with federal deposit insurance up to $250,000. At the end of the CD's term, you get back the original investment amount plus any remaining interest. However, if you redeem the CD before it expires, you likely will pay an early withdrawal penalty or forfeit a portion of unpaid interest.
Interest rates increase along with the length of your commitment. There sometimes can be as much as a full percentage point difference between a six-month CD and a five-year CD. The investment risk comes in trying to predict the direction of interest rates when picking an investment term. If interest rates rise, you would like a shorter term so that you can reinvest the money at a higher rate. But if interest rates fall, you would like a longer term so that you receive the higher rate longer. For example, the average one-year CD rate was a little over 7 percent in 2000 and about 7.5 percent for a five-year certificate. One year later, the one-year average had dropped to 4.5 percent, but if you had picked a five-year CD, you still would have drawn 7.5 percent on your investment for four more years.
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Issuing institutions typically separate regular CDs from CDs held in an IRA, and they designate specific interest rates for each type. Although there usually is little or no difference in the rates paid for the same term, when there is a variance the IRA CD generally gets paid the lower rate.
Because of tax considerations, there sometimes is a difference in the frequency of interest payments between CDs held in and out of an IRA. Interest on regular CDs generally will be paid more frequently – at least on an annual basis – while interest on IRA CDs is more likely to be held until the end of the term. Tax on CD interest earned outside a tax-sheltered account must be paid the year it is earned. The interest on IRA CDs is not taxed until it is withdrawn from the account, usually not until you're at least 59 1/2.
If you invest $100,000 or more in a CD, you typically can get a slightly higher rate. Particularly in an IRA, you can squeeze a little more tax-sheltered income by using a jumbo CD for money you feel safe you won't need to withdraw during the term of the CD.
Brokerages gain favorable interest rates by buying CDs in huge denominations from a bank. The firms then divide those CDs into smaller units and resell them to their customers, often providing a higher rate than a bank would offer an individual on a similar CD package. These brokered CD units still are FDIC-insured up to $250,000 per signature on the account and come in a typical range of maturities. Because brokered CDs can be traded on a secondary market to the firm's other customers, the companies issuing the unit typically allow you to get out of a brokered CD for a small trading fee. This may be particularly advantageous in an IRA account, allowing you to park funds in a brokered CD during a falling stock market, then putting the money back into stocks when you expect them to rise.