High savings rates have thrust certificates of deposit (CDs) into the limelight in recent years. When rates were low, CDs were a relatively underutilized workhorse for savings. But when top CD rates rose to 5% or more, they became savings superstars.
CDs are popular with retirees who want a low-risk way to earn predictable returns, especially since you can buy CDs through top brokers as well as banks. You can even put CDs in your Individual Retirement Account (IRA).
But CDs are only useful in certain scenarios. Even before rates started to fall, they weren’t a financial magic bullet. Here are three reasons to park your money elsewhere.
1. Rates are falling
The Federal Reserve just cut its benchmark interest rate for the first time in over four years. Sure, that 0.5% discount alone won’t make that much of a difference to your CD earnings. But it won’t be only be 0.5% — this is likely the first in a series of rate cuts. We can expect to see rates on savings accounts and CDs drop steadily over the next year or two.
Some argue that falling rates are all the more reason for retirees to lock in relatively high rates while they’re still available. That’s understandable. Be aware that any money you lock up in a CD is money you can’t use for other things.
If you haven’t saved as much as you’d hoped for retirement, that’s money that isn’t earning higher returns through investments. Buying stocks carries more risk than CDs, but investing in stocks can seriously outperform them, too.
2. You have to pay taxes on CDs
The IRS considers any CD interest over $10 as taxable income. Unless you put your CDs in a tax-advantaged account like an IRA, your interest payments will be taxed at the same rate as your salary or other income.
Let’s say you have $2,000 in a 3-year CD paying 4.5% APY. You would earn $90 in annual interest. If you’re in the 22% tax bracket, you’d pay almost $20 in tax each year. This essentially lowers the APY by almost 1%. You would still be ahead of inflation, but not by much.
Taxes on CD interest work differently than those on long-term investment earnings. First, if an investment increases in value, you only pay taxes when you sell the asset and realize those gains. Second, if you hold the asset for more than a year, you will pay long-term capital gains tax rates that are likely to be lower than your income tax rate.
3. Your money is tied up until the end of the CD term
For the most part, when you put money into a CD, you’re committing to leaving it alone. You will have to pay an early withdrawal penalty if you want to get to it before the end of the term. That means CDs aren’t a great place to put money that you might need to access at any time, such as emergency savings.
The Fed’s decision to cut rates means we are in a period of change that may bring opportunity. But it’s harder to jump on new — potentially more profitable — options if your money is tied up for long periods of time.
Building a CD ladder can help mitigate this risk. This involves splitting your money and putting it into several CDs of different lengths so that chunks of your money aren’t locked up for so long. Even then, CDs are relatively illiquid and don’t give you much room to work with.
Forget CDs — there are better places to put your money
It’s easy to understand the appeal of a low-risk savings account that pays predictable returns, especially if you’re retired and don’t want to take unnecessary risks with your nest egg. But it’s very important that your retirement savings don’t stagnate. This can happen if you put too much into the CDs.
Here are other things to do with your money:
- Invest in bonds: Now that interest rates are falling, bonds are gaining traction again. Bonds have had a rough couple of years, but they’re a great alternative to CDs. They can provide a steady income and often perform well when rates drop.
- Pay off high interest debt: If you have a balance on your credit card, you may be paying more than 20% interest. That beats every CD on the market, as well as many other investments.
- Buy dividend paying stocks: Dividends are a way that companies share their profits with shareholders. Not only can these payments be a good source of income for retirees, but the shares themselves can also appreciate in value.
Structuring your retirement portfolio is not easy, and there is no single “right” answer. CDs can play their part, but diversification is crucial so you’re not dependent on any one investment. The rest depends on your needs, risk tolerance and broader financial plan.
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