A Beginner’s Guide to Investing in an IRA CD

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Deciding to save up for retirement is easy. The challenging part is choosing the right retirement plan to invest in.

Luckily, there are many viable options, and sometimes, you don’t have to choose because you can have it all.

For example, you can have an IRA CD if you’re torn between investing in a Certificate of Deposit (CD) and an Individual Retirement Account (IRA).

The IRA CD comes with several combined benefits from all accounts, which we will explore in this article.

What Is an IRA CD?

An IRA CD is a hybrid investment combining a CD and IRA account. It provides a fixed interest rate, tax-free dollars after retirement, and other tax advantages. The benefits you get from an IRA CD can vary based on the type of IRA you invest in.

How an IRA CD Works

An IRA CD account is the same as a traditional CD in that the money is locked for a specific time, and the longer the period, the higher the interest. However, an IRA CD offers a fixed interest rate unlike traditional savings accounts.

Also, unlike regular CDs, IRA CDs are specifically meant for retirement savings. This means they’re subject to the rules and tax laws for retirement savings accounts by the Internal Revenue Service (IRS).

With IRA CDs, also known as retirement CDs, you receive a fixed interest rate for your savings, which means rate fluctuation doesn’t affect your income. You get a fixed interest income, meaning you can plan for your retirement easily, unlike with other investments such as stocks.

Obviously, some riskier investments have the potential for higher returns, but if you’re looking for stability, an IRA CD will give you that.

Example of an IRA CD

For a better understanding of how the IRA CD works, let’s try a real-life example.

We will use Olivia, who is 30 years old and just opened a traditional IRA CD account. She deposits $3,000, and the fixed interest rate is 3%. This means by the end of her first year, Olivia’s money will have earned $90, and her total balance will be $3,090.

At the end of the year, Olivia can decide to re-invest her $3,090 or move her funds to another type of IRA CD and choose a different term. It could be six months or five years, depending on her preference and needs. At the end of the first year, Olivia can deduct $3,000 from her taxable income.

Now let’s say Olivia decides to withdraw her money and invest in a non-IRA account, like investing in the stock market. In this case, she’ll be penalized by the IRS for early withdrawal, as she’s below 59.5 years of age. She’ll also be required to pay income taxes for the withdrawn funds.

Types of IRA CDs

In our previous example, Olivia was investing in a traditional IRA CD. However, there are other types of IRA CDS. Let’s discuss all the characteristics of a traditional IRA account and then move on to the others.

Traditional IRA CD

A traditional CD is very similar to a traditional IRA.

  • You contribute to your account and can deduct the amount from your taxable income while filing taxes.
  • Your IRA CD earnings are tax-free until retirement; you pay for taxes when withdrawing the money.
  • You must wait until you’re 59.5 years of age and above to withdraw the funds. Otherwise, you’ll pay a 10% penalty to the IRS. The withdrawn funds will also be eligible to tax.
  • You must start withdrawing the funds once you’re 72 years old, as IRA CDS are subject to required minimum distributions (RMDs).), just like traditional IRAs.

Roth IRA CD

The Roth IRA CD works very similarly to the Roth IRA.

  • You fund the account with after-tax dollars meaning that you contribute to the IRA CD and aren’t eligible for a tax deduction.
  • Your earnings are tax-free.
  • The funds you withdraw aren’t taxed.
  • You can withdraw the funds before the age of 59.5, but you’ll have to wait until your IRA CD account is at least 5 years old and you're 59.5 years old to withdraw the contributions penalty-free.
  • A Roth IRA CD isn’t subject to required minimum distributions (RMDs), so you can withdraw the contributions at your own pace.

SEP IRA CD

This isn’t a very common account, but some banks make room for it to accommodate self-employed people.

A SEP IRA CD is similar to a traditional IRA CD:

  • You contribute taxable funds, so you pay taxes when withdrawing the money.
  • You can deduct your contribution from the taxable income when filing taxes
  • The funds are subject to RMDS, so you must start making withdrawals at age 72.

Pros and Cons of an IRA CD

Described below are the bad and good of investing in an IRA CD account:

Pros

  • Tax benefits

IRA CDs are eligible for all the tax benefits of IRAs. If you invest in a Roth IRA CD, you can clear your taxes upfront and withdraw tax-free dollars after retirement. If you want to pay taxable dollars, you can open an IRA CD and deduct your contribution from your taxable income.

  • Guaranteed returns

This is the biggest pro of investing your money in an IRA CD. You get a fixed interest rate, so you don’t have to deal with fluctuations or lose the value of your money as you retire.

  • Low-risk investment

If you’re afraid of investing and losing all your money on retirement, IRA CDs are among your safest options. They’re insured by the National Credit Union Administration (NCUA) or Depository Insurance Corporation (FDIC). You’re, therefore, guaranteed that you’ll not lose your money or the value of your money.

  • Good option for retirement

If you just started saving for retirement and are retiring soon, IRA CDs should be on your consideration list. They’re a good choice because they’re FDIC-insured and guaranteed returns. Unfortunately, you might miss out on the higher returns you might have earned with a regular IRA.

Cons

  • Lower yields for your contributions

One of the drawbacks of investing in an IRA CD is the possibility of low yields. Regular IRAs have a higher potential to earn more as they comprise mutual funds, stocks, EFTs, and bonds.

  • Double penalty for early withdrawals

If you withdraw a regular IRA before age 59.5, you only have to deal with the IRS penalties. However, with an IRA CD, you pay a penalty to the IRS, and the bank will charge you for early withdrawals.

  • Require an opening deposit

If you choose to invest in a regular IRA, you don’t need to have any money. You can open an account with $0. Opening an IRA CD account requires a minimum deposit.

  • No income increase claim if CD rates rise

As aforementioned, with IRA CDs, you get a fixed interest rate. While that’s a pro for those wanting a safe option, it can also be a deal-breaker. If you open an IRA CD and later on the rate increases, you can’t claim an increase in your earnings. This is unless you go with a _step-up CD account _that allows you to raise your rates during your CD term.

  • Not ideal if you’re years away from your retirement

IRA CDs have historically had lower returns than regular IRAs. This makes them an undesirable option if you still have many years before retirement. For example, if you’re 10–15 years or more from retirement, you have enough time to rebound from any volatility in the stock market. Therefore, going with the IRA CDs would mean losing out on earnings you don’t have to miss out on.

IRA CD vs. Regular CD

Before we explore how an IRA CD is different from a regular CD, let’s explore their similarities:

Similarities
  • They both earn a fixed interest rate.
  • They’re offered by credit unions and banks.
  • Their terms range from 3 months to 10 years.

Now here are their differences:

IRA CDs Regular CDs
Purpose They are strictly for saving up retirement money. They are not necessarily for retirement purposes. You can open a regular CD to save up for your children’s college fees, a new house, a new car, a wedding, a trip, or any other project.
Tax advantages You can enjoy a tax break now or after retirement, depending on which account you open. There are no tax advantages. All the interest earned from them is eligible for tax.
Penalty Early withdrawals attract two penalties: one from the IRS and another from the bank. For early withdrawals, you pay only the bank a penalty.
Note: Roth IRA CDS and Traditional IRA CDS have the same contribution limits. In 2023, the limits are $6,500 and $7,500 (for those above 50 years of age). For 2022, these limits are $6,000 and $7,000, respectively.

IRA CD vs. Roth IRA

Both the Roth IRA and IRA CD are great saving retirement plans. They come with benefits such as earning tax-free dollars and withdrawals after retirement. However, the similarities end there.

Here’s how the IRA CD and Roth IRA differ:

IRA CDs Roth IRA
They earn a fixed interest. Their returns are unpredictable, as they’re subject to stock market volatility.
They typically have lower returns than Roth IRAs, especially when the investment period is long. They usually have higher returns than IRA CDs.
They are FDIC-insured, so they can’t lose value. They are SPIC-insured, meaning they can lose value.
They are offered by credit unions and banks. They are offered by brokerages.
They comprise CDs only. They comprise EFTS, bonds, stocks, mutual funds, and more.

How Are CDs Taxed?

The interest earned is considered taxable income, and the tax rate you pay for the interest earned from your CDs is the same as that of your ordinary income. Here’s how different CDs are taxed:

  • Short-term CDs: If you have a six-month CD and earn more than $10 interest, you’ll have to report the interest earnings for that year while filing taxes.
  • Long-term CDs: A long-term CD means you’ll earn interest in more than one calendar year. In this case, you’ll have to pay taxes for the interest accrued yearly. For example, if you have a five-year CD and earn $400 as interest for the first year, you’re required to report it as tax. If your principal makes $500, you’ll be required to report it as taxable income, too; this goes on for the remaining three years.
  • IRA CDs: If you want to avoid taxes, you can hold them in a traditional IRA; in this case, any money contributed to the account is tax deductible. Like a traditional IRA, you’ll pay taxes when withdrawing funds after retirement. The contributions are not deductible for Roth IRA CDs, but you get to enjoy tax-free dollars after retirement.

Who Is an IRA CD For?

Understanding different types of retirement account plans can help you make an informed decision. An IRA CD account is suitable if:

  • You’re retiring soon and have no time to let the stock market rebound.
  • You want stability; an IRA CD has a fixed interest rate, so there are no surprises after retirement.
  • You’re looking for a low-risk investment. An IRA CD is FDIC-insured, so you’re guaranteed you won’t lose your money. And your money won’t lose its value either.

If you’re unsure what retirement plan is best for you, we recommend talking to a financial advisor. You can also browse through our tax tips for more information.

Summing up

Embarking on the journey to secure your retirement funds is undoubtedly a significant step. The complexities arise in choosing the ideal retirement plan, yet there's a versatile solution that bridges the gap between options: the IRA CD.

An IRA CD serves as a hybrid investment that combines the best of both worlds, blending the stability of a Certificate of Deposit (CD) with the tax advantages of an Individual Retirement Account (IRA). This symbiotic relationship yields fixed interest rates, tax-free retirement funds, and the security of FDIC or NCUA insurance. Whether you opt for a traditional IRA CD, a Roth IRA CD, or even a SEP IRA CD tailored to self-employed individuals, the appeal lies in the peace of mind they offer.

While IRA CDs promise assured returns, they do come with trade-offs. As you deliberate between investment options, consider your proximity to retirement, your risk tolerance, and your preference for stability or potential gains. Ultimately, the decision hinges on your individual financial goals. Before you take the leap, consulting a financial advisor can provide tailored insights to guide you toward a well-informed choice.