If you are investing for a retirement that is still many years away, CDs might not be the best choice, because you run the risk of losing money in the long run due to inflation and taxes. Learn more about when and why CDs are a good investment choice and when and why they are not.
Risk of Loss With CDs
It is possible to lose money even on a safe retirement investment like a CD, which, like other kinds of bank deposits, is guaranteed by the Federal Deposit Insurance Corporation (FDIC). The rate of interest on CDs is often less than the rate of inflation. When combined with federal and state income taxes on the interest, you can lose money over time in investments like CDs that appear to be safe and secure. For example, suppose you are considering a $10,000 CD that would mature in five years. It pays 3% per year in interest, so it would produce an additional $300 per year. If you pay taxes at a 25% federal rate and a 5% state rate, you’d owe $90 in taxes on the CD interest just in the first year. If inflation is 3% per year, at the end of the year, you would require $309 to buy $300 of goods and services. After taxes, your CD would have delivered just $210.
Planning for Retirement With CDs
If you take the time to design a retirement plan, you should know what minimum rate of return you’ll need over the years if you’re going to achieve your retirement goals. If you need only a 4% rate of return to meet your retirement goals, and you can find a CD that pays 4% or more, a CD might be a good choice for you. In this case, you might be able to create a CD ladder through which your CDs mature on different dates leading up to your target retirement date. Doing so can help you hedge against a decrease in interest rates. If the CDs don’t achieve the rate of return you need to achieve your goals, you will still have a few possible solutions. You can reinvest in other retirement vehicles as each CD expires, ones that might achieve a higher rate of return. Alternatively, you might decide to work longer or find a way to reduce living expenses so you can achieve your goals on the returns offered by your CDs.
Who Are the Best Candidates for CDs?
In general, CDs are a good investment if you are in a low tax bracket, want no investment risk, have a primary goal of preservation of capital (rather than growing capital), and plan to use the funds at a time that matches the CD maturity date. It is also important to know whether you can lock in a rate of return higher than the rate of inflation over the time period you need. For example, if you are in a low tax bracket and don’t need the funds for 10 years, a 10-year CD that pays 5% would be a good investment if you expect inflation to be 3% or less.
Who Are the Worst Candidates for CDs?
CDs are likely a poor choice if you believe you would be losing money after you factor in taxes and inflation, have a primary investment goal of growth or steady income, or need to be able to withdraw your money at any time. CDs are not a liquid investment. You can’t withdraw your cash early without incurring penalties. Anyone who needs ready access to their cash would be a poor candidate for long-term CDs.
Using CDs in Retirement
While CDs may not be a good investment for a retirement that is still several decades away, they could be a useful tool once you are already retired or close to retirement age. Storing money that you don’t need immediately in a CD allows you to continue earning interest, which can increase the amount available to you during retirement. The shorter investment timeline means that the interest on your CD is more likely to be able to outpace the rate of inflation. Other investments that you can use to help your money grow in retirement include high-yield savings accounts, interest-bearing checking accounts, and money market accounts. As always, when planning for retirement or managing your money while retired, it is helpful to hire a financial advisor who will understand your particular financial circumstances.
