What is an IRA CD? How do they work?
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Updated: December 01, 2023
Anyone saving for retirement in this inflationary climate should consider contributing to a certificate of deposit (CD), which is a sum of money invested for a predetermined, specified amount of time. For someone who’s nearing retirement, or in retirement, many lenders offer a CD designed for an Individual Retirement Account (IRA), known as an IRA CD.
What is an IRA CD?
The idea behind a CD is that you can’t access it for a set period of time without losing interest or maybe even paying a penalty. Unlike a savings account, it doesn’t have the ease of accessibility, including deposits and withdrawals. All that’s required is a lump sum and the rate of return and the length of the term is set. After that, it’s best to forget about it until it comes due.
CDs haven't always been an investment vehicle people gravitated to. CDs have been around since the 1960s but had gone out of favor in recent years due to ultra low rates, usually averaging far less than 1%. They’ve gained in popularity because lenders are offering a solid 5% or more on these extremely safe little workhorse investments.
The returns on a CD are higher than usual right now, because the Federal Reserve has increased rates to fight inflation. As well, CDs designed exclusively for individual retirement accounts (IRAs) make it an easy option, and a low-risk way to grow money for retirement. That’s because the lender not only guarantees the rate of return at the outset, but also because the Federal Deposit Insurance Corp. (FDIC) guarantees up to $250,000 per IRA per person at qualifying banks. Credit unions are guaranteed by the National Credit Union Administration. If you plan on investing more than $250,000, it may be a good idea to hold different CD investments across several lending institutions, or put them in your spouse’s name.
An investment strategy called “CD laddering” involves investing equal amounts of money across several CDs so that they come due at different points, allowing you to reinvest the money, plus interest, so it grows like a snowball. When one matures, you reinvest the money into another CD—or, you can access the money without paying a penalty, if you need it.
For example, a mini CD ladder could be built out of a 3-month, 6-month, 9-month and 1-year CD strategy.
The decision to add a CD to an IRA will depend on your investing goal, your tolerance for risk, and when you’re going to need access to the funds. And considering stock market uncertainty, a CD offers a low-risk option to keep the IRA growing and diversified without rolling the dice.
What are the best IRA CD rates?
Not so long ago, when inflation was a distant memory and borrowing rates were ultra-low, nobody gave much thought to purchasing a CD, with its paltry rate of return. Today, CD rates are over 5% but the national average rate of a one-year CD was a low 0.14% as of March 15, 2021.
How times have changed. But when considering a CD, remember that the rate isn’t the only factor. Consider how long you might want your money tied up, which is a range of months to years. As well, some CDs offer perks, such as a bump-up option, which permits a one-time increase in the interest rate, while others may come with a minimum deposit. Also, consider penalties for withdrawing before the due date, which can be steep. And even though they’ve become popular with consumers, not all lenders offer special IRA CD options.
Not all CDs are created equal. When purchasing a CD, it’s best to shop around for the best annual percentage yield (APY) and terms. We’ve cobbled together a few of the better rates currently on offer.
IRA CD vs. regular CD
There are key tax implications when deciding between a regular CD and an IRA CD. Interest on a regular CD is taxed just like income earned throughout the year. If you have an IRA CD, the interest is tax-deferred until you retire.
If you buy a regular CD through your bank account, there is no limit to what you invest. If you’re buying through an IRA, however, there are annual contribution limits. For 2023, the IRA contribution limit is $6,500 for a person under 50 and $7,500 for a person over 50.
IRA CD pros and cons
IRA CD contributions are limited. And if you withdraw money early from an IRA CD, the penalties could be substantial. You could be looking at a penalty on the CD as well as a penalty from the IRS. Accessibility to emergency funds can be difficult, you may have several accounts to keep track of if you are trying to take advantage of different rates, and your funds are locked up. In other words, they lack flexibility.
The key benefits of an IRA CD is the tax-deferred investment growth, the safety of an insured investment product, the guaranteed return rate, and the knowledge that you will be earning a predetermined amount. You won’t need to keep an eye on how your investment is doing.
IRA CD pros
Holding an IRA CD during stock market uncertainty can be a worthwhile short-term investment because a CD is impervious to market cycles. And right now, the average CD is performing better than most savings accounts. If you have cash sitting around because you plan on using it to buy a house or pay down bills one day, you may as well put it into a CD so it can grow a little while it’s sitting there.
They’re about as straightforward as it gets. Even Ramsey Solutions says “they’re about as set-it-and-forget-it as they come.”
They’re safe, federally insured up to $250,000. It’s nearly impossible to lose money on a CD—other than tying up your money where it could earn more elsewhere.
A CD may be a conservative investment, but it also offers diversity within a portfolio of riskier investments. And if you choose a three, six or 12-month term, it offers short-term cash flow. Just remember it’s not liquid, so not the greatest for an emergency fund.
And if it’s tucked inside an IRA, there aren’t any capital gains taxes on your investment gains. Think what a large sum of money could generate within a year, without risking the principal.
IRA CD cons
The point of a CD is that you’re going to leave it alone for a set amount of time, in exchange for a guaranteed rate of return. But a CD can take up a lot of space within an IRA, which is currently capped at $7,500 if you’re over 50. That limits investing power that could go towards something that offers higher returns over the long term, such as stocks.
In a low-interest rate environment, a CD makes no sense because the returns are so small. The current climate is the first time in a long time when they make more sense. Financial advice site Ramsey Solutions has few good things to say about the product, calling it a glorified savings account: “Basically, it’s like giving a bank or credit union a loan from your own pocket. In exchange for lending them a lump sum of your money for a fixed amount of time, they agree to pay you interest until the CD ‘matures,’” the financial expert writes. He calls them “low risk, but also mostly low-reward.”
Because an IRA CD is such a conservative investment, for a younger IRA owner who’s got time on their side, it might be playing it a little too safe.
The other con is that you’re locked in, so if you suddenly need cash and it’s tied up in a CD, you’re out of luck—unless you opt to pay the withdrawal penalty. Those penalties could be a flat fee or a percentage, and in some cases, could even wipe out any interest accrued.
As well, if CD rates do go up even higher, you’re locked in at the lower rate that you started with. (For longer term CDs, a holder might go for a “bump-up” option, which allows one or two rate increases before locking in.) Another risk is inflation. If it climbs while your money is tied up in a CD, there’s potential loss of purchasing power. That’s a particular risk if it’s a long-term CD with several years to go before it comes due.
Are IRA CDs a smart investment?
It depends who you ask. CDs are an easy investment that don’t require much know-how. But to offset the cycles of the market, financial expert Dave Ramsey recommends a diversity of mutual funds as the better investment, such as growth and income, growth, aggressive growth and international. A mutual fund is a group of investments such as stocks and bonds managed by a company that does the diversification for you. They have more growth potential than a CD, and offer the flexibility of buying and selling shares any time you like. And while they aren’t entirely without risk, mutual funds are considered less risky than playing the stock market because they are professionally managed and diversified. But there are fees, and unlike a CD, the returns will generally go up and down. That’s why mutual funds are best used as long-term investments.
Choosing a mutual fund takes a little more know-how than a CD, such as learning the basics of asset allocation and fee structures, as well as reviewing how the mutual fund has performed. But Ramsey says that $5,000 invested in a growth stock mutual fund, with a track record of good returns, could bring in $8,000 after five years based on an average rate of 10 to 12% rate of return.
Investment adviser Dan Casey, who’s with Bridgeriver Advisors, advises a CD term no longer than 12 to 18 months in the current market conditions. That’s because of the inverted yield curve, which means shorter term CDs are paying higher yields than the longer term CDs. It’s an unusual situation because typically investors are rewarded for hanging in for the long term.
Because of that short-term reward, it doesn’t make sense to go for a long-term CD.
IRA CD FAQs
Kerry Gold is a long-time journalist. Based in Vancouver, she's written a weekly real estate and urban issues column for the Globe and Mail for the past 15 years. She is the author and co-author of several books, and several investigative pieces for the Walrus and other publications. Prior to her freelance career, she was an entertainment reporter and music critic for the Vancouver Sun.
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