What Is an IRA Certificate of Deposit (CD)?

What Is an IRA Certificate of Deposit (CD)?
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While you might most often think of an individual retirement account (IRA) containing investments like stocks, mutual funds and bonds, you can actually have an IRA account with funds invested in certificates of deposit. This option gives you the same choice to choose a traditional or Roth IRA account with the same rules on tax benefits and penalties, distributions and qualifications.

IRA CDs can provide benefits to more risk-averse investors who don't need a high return, but these accounts also have their downsides. Learn more about how an IRA CD works and what this CD option involves.

Basics of an IRA CD

As with any kind of IRA, you'd open an IRA CD for the purpose of long-term retirement savings where you don't withdraw money until you are at least 59 1/2, which is the age at which the Internal Revenue Service allows penalty-free withdrawals of contributions and earnings. The main difference is you invest your money in CDs rathern than riskier investments such as stocks.

CD accounts are similar to savings accounts in that you get a certain guaranteed interest rate, except you agree to a CD term ranging from days to many years during which the money stays in the account, or else you face an early withdrawal fee.

Since this is a type of IRA, you have to comply with the IRS rules governing these accounts when you invest money. For example, people under 50 in 2020 can only put a max of $6,000 total in IRA accounts, while older people can invest $7,000. If your taxable income is less than these limits, than that amount becomes the new minimum. Further, if you're using a Roth IRA CD, contributions can get lowered or phased out by income and filing status.

To avoid bank fees, IRS penalties and extra taxes, you're not intended to end a CD early or withdraw money from your IRA CD, and as an IRA CD matures, you can renew it or put the money in another investment within your IRA. You'll usually be able to withdraw money freely once you turn 59/12, and traditional IRAs will have a mandatory age of 72 when you must take distributions of a minimum value or face extra taxes. The IRS does make exceptions for early withdrawals if due to certain hardships, and Roth IRAs allow for more flexibility to withdraw contributions early.

Traditional vs. Roth IRA CD

When choosing an IRA CD for your retirement savings, you can open either a Roth or traditional IRA account. These mainly differ based on eligibility, suitability and the tax handling of contributions and withdrawals. So, each may fit different financial situations and preferences.

With a traditional IRA CD, your contributions get deducted from your income (either fully or partially based on income and filing status) for tax filing purposes, which means less taxable income now. When you take withdrawals in retirement, you'll then pay taxes on the money at the current tax rate at the time. The IRS also requires mandatory distributions for this type once you turn 72. Anybody with earned income can open this kind of IRA CD since no income ceilings apply.

Roth IRA CDs, on the other hand, don't have their contributions subtracted from your income, so you pay taxes on the money when you file your return. This means you enjoy tax-free qualified distributions during retirement, and after you've had the account for five years, you can even make early withdrawals of the contribution (not earnings) without penalty. You also don't have to worry about mandatory distributions. However, the IRS rules limit or prohibit contributions based on your filing status and income, so you may not qualify for this kind of IRA CD.

Benefits of IRA CDs

IRA CDs have some unique advantages that can make them appealing to investors who prefer to reduce risk. Here are some main reasons why some retirement savers might choose these accounts:

  • Locked-in interest rate: If you're someone who wants to know exactly the interest rate you'll earn on an investment and not have to worry about fluctuations with the market, then an IRA CD offers this peace of mind. Your bank's terms lay out the rates offered for IRA CDs of different lengths, and even if rates drop significantly during that time, it won't impact you during the term.
  • Security for those nearing retirement: While younger investors may feel comfortable with riskier stocks and bonds in their IRAs, those nearing retirement may prefer something guaranteed and stable. Since IRA CDs are available with short terms, you could invest in these accounts a few years or even months before retirement and not worry about the ups and downs of the stock market hurting your retirement goal.
  • Flexible terms: Since IRA CDs come with varying term lengths, they can fit your needs regardless of how far away you are from retirement. If you still have a decade to go, you can open a long-term IRA CD with a 10-year term or choose a three-month one if you're close to retiring. Shorter terms offer more flexibility for reinvesting funds after maturity and taking advantage of higher-rate investments.
  • FDIC insured funds: Along with the security a locked-in rate gets you, your IRA CD gets further protection from loss thanks to Federal Deposit Insurance Corporation protection. While money you invest in bonds or stocks isn't insured, IRA CDs are for up to $250,000 per depositor at the bank. If you want to put more money in IRA CDs and do so within the IRS contribution limits, you could always open another at a different bank and get that FDIC coverage limit there too.
  • Potential tax benefits: Depending on whether you open a traditional or Roth IRA CD and what your financial situation looks like, you could get different tax benefits. If you make a lot more money now than you plan to in retirement, a traditional IRA CD lets you deduct your contributions now and pay taxes on your distributions when you're earning the lower income in retirement. On the other hand, a Roth IRA CD may not give you immediate tax benefits, but you'd enjoy tax-free distributions in your retirement years.
  • Simple setup: When opening an IRA, you may find it hard to choose how to allocate bonds, stocks, mutual funds and other investments into your portfolio. Investing in an IRA CD is much simpler since you have less risk to worry about and just need to decide on whether you want a traditional or Roth version.
  • Easy to avoid fees: Avoiding fees with an IRA CD is as easy as leaving the money alone until maturity and not taking money out of the IRA before you qualify during retirement. Other types of IRA investments, on the other hand, can come with costly commissions and transaction fees.

Drawbacks of IRA CDs

Before choosing an IRA CD, know that you'll need to consider some disadvantages that can vary between Roth and traditional accounts.

Some common disadvantages of IRA CDs include:

  • Low return: If you need to get a high return on your investment, then an IRA CD may not appeal to you, especially if you're far away from retirement. After all, the IRA CD may have a 1 percent interest rate compared to a 10 percent average return you may get on stocks. The fact that the interest rate on an IRA CD is fixed can add to the disadvantage when rates end up rising during the term.
  • Limited liquidity: Like with other CDs, you can run into some problems if you need quick and easy access to your money, and this gets further complicated with IRA CDs. First, consider that most CDs will charge an early withdrawal penalty to get the money before the term runs out, and this usually means losing interest. Second, IRAs come with an early withdrawal tax penalty as well, unless you qualify based on extenuating circumstances or follow Roth IRA early withdrawal guidelines.
  • Minimum investment requirement: Banks set their own requirements for the minimum deposit for an IRA CD, and this can mean you need to do careful research based on what you can afford to invest. While you can find IRA CDs with no minimum, having to invest between $1,000 and $5,000 is more common. Such amounts can vary by term, too, where shorter terms require a higher investment.
  • Contribution limits: Unlike with other types of CDs, you have to follow the IRS contribution limits for IRA CDs, and this can make it harder to invest as much in a CD as you'd like. Keep in mind that even if you open multiple IRA CDs, this won't allow for higher annual limits.
  • Eligibility requirements: Depending on your employment situation and income, you may not be eligible for any kind of IRA CD. For example, you need to have earned income for a traditional account or make below the IRS limits for a Roth account. In the case of Roth IRA CDs, even if you do qualify, your contribution limit can be lowered if you make a higher income or are married and filing separately.
  • Penalties for withdrawals: The bank where you get the IRA CD will charge you some penalty, often a certain number of months of interest earned, if you take the money out early. If you end up withdrawing the money completely from the CD and aren't 59 1/2 or older, then you face a 10 percent tax penalty from the IRS for traditional IRA CDs and will need to pay taxes on any withdrawn investment earnings for Roth IRA CDs.

IRA CDs vs. Other CDs

Whether you're not sure about using an IRA CD for retirement or just want to know other CD options, it helps to take a look to see how other types of CDs work. However, keep in mind you don't get the unique tax benefits IRA accounts would offer.

  • Jumbo CD: Since the IRA contribution limits don't apply, you can invest a large sum of money, such as $50,000 or $100,000, and shop around for a good return. You can find long terms that may suit retirement savings goals but can cash out the account at maturity with no IRS penalty.
  • Traditional CD: If you have a smaller savings goal, a traditional CD can offer a slightly lower return than jumbo CDs but require a lower minimum investment.
  • Liquid CD: Also referred to as a no-penalty CD, you get much better liquidity than an IRA CD, since your money is yours to take out without penalty after a small holding period. However, this means closing the account and usually receiving a lower interest rate for the extra flexibility.
  • Add-On CD: Harder to find, this kind of CD is like an open box where you can add money after your initial deposit, as long as you follow the bank's rules.
  • Bump-Up CD: If having an option to take advantage of a higher rate later sounds appealing, a bump-up CD allows for this, though you're betting on the idea that the interest rates will rise during the term. This might mean you decide to just keep your initial rate in the end.
  • Brokered CD: Available through investment firms, this CD can result in a better yield. If you need the money before maturity,  you sell the CD on the secondary market versus cash it out early through the bank directly.

Now that you know how IRA CDs compare to other types, consider meeting with a financial advisor to decide which best fits your retirement plans and other savings goals.