We have talked a lot about 401k’s and rolling over your employer-sponsored 401k into a either a traditional IRA, or a Roth IRA account when you leave your employer.
While IRAs offer several tax benefits, there are reasons you might consider depositing those funds into a Certificate of Deposit (CD).
What is a Certificate of Deposit (CD)
A CD is a specialized account that offers higher interest rates than a standard savings account. CDs also tend to have fixed timeframes, such as six, twelve, or twenty-four months, within which you cannot withdraw the funds. CDs are considered relatively low-risk with a fairly high rate of return.
You would purchase a CD from a financial institution, such as a bank or brokerage firm, with a set time period. During the time you hold the CD, the bank will pay interest on the deposit amount. The frequency at which the financial institution pays the interest depends on the terms of the CD — in most cases, the interest is paid monthly.
With a traditional CD you cannot withdraw money from the CD before it matures, or reaches the end of the time period. If you do, you could be required to pay a penalty for early withdrawal, or lose some or all of the interest accrued to that point. Once the CD matures, the bank will cash the CD in and distribute all of the funds in the account to you to do with as you please.
CDs are FDIC insured up to $250,000. This means, if the bank that issued the CD closes before the CD matures, you can recover the full balance of the CD as long as it is below $250,000. If the balance of the CD is above $250,000, you can only recover up to $250,000.
Some financial institutions offer CDs that have more flexible interest rates, and may also allow you to withdraw money from the account with few-to-no penalties. These products are usually specific to the banks in question, and the way they work depends on the terms set forth by that bank.
Why Open a CD?
Traditional CDs are good for situations where you want to deposit one lump sum and let it accrue interest over a set period of time. Since you can’t touch the money until the CD matures, you can be certain that you won’t end up withdrawing the money early, as you would with a standard savings account.
Traditional CDs are considered a fairly low-risk investment because you earn a fixed interest rate for the life of the CD. This fixed interest rate is independent of market fluctuations. This means that if the market drops, you will still earn the same amount of interest.
Traditional CDs only last a certain amount of time. Unlike an IRA or a 401k, which can go on indefinitely, you can set the CD to mature within months. This allows you to have access to your funds faster, and without some of the hoops and paperwork associated with withdrawing from an IRA or 401k.
Finding a CD
The easiest way to get a CD is to open an account at an FDIC-insured bank. Choosing a bank in your city or neighborhood provides a degree of familiarity with the people in charge of managing your money. But a local bank might not provide the best CD rates — whereas an online institution could offer the best 6 month cd rates around.
However, you should also be wary of institutions that offer CDs with rates far above the average. Your best option is to do research on the average rates, and compare the CD offerings from multiple providers.
One way to do this is to walk into several banks and pick up brochures. But you can also do a simple online search for the best CD rates or the best 6 month cd rates, including the name of your city or town. A web search will return results for comparison sites as well as individual financial institutions.
Before You Buy
Make sure you fully understand the terms of the CD. If necessary, have a financial professional go over the paperwork with you to make sure everything is clear. You should also ask very specific questions before you sign on the dotted line:
- Is the financial institution FDIC insured? Not all institutions are. One way to find out is to go the FDIC’s Bank Find website and search for the name of the bank. You can also call the FDIC at (877) 275-3342.
If you are working with a broker, it is up to him to make sure he puts the funds in an FDIC insured bank. If you are not sure you can trust him to do this, consider purchasing a CD directly from a FDIC-insured financial institution, rather than using a broker.
- Is the CD FDIC insured? A traditional CD should be insured, if it is opened at an FDIC-insured bank. However, some non-traditional CD products could be designated as a non-deposit investment product, and will not be covered. Before you sign, make sure the CD account is designated as a deposit investment product, and is subject to FDIC insurance.
If you are working with a Broker, carefully review the account documentation, and have it reviewed by a financial professional if necessary, to verify the CD is designated a deposit account.
- Are there any strings attached? Once the CD matures, you should be able to get the principle, or the amount you originally deposited, back with no further obligation to the bank. If the CD contract puts any contingencies, or strings, on the principle, it might not be a valid CD. One example of a contingency is that the bank requires that you have earned a certain dollar amount in interest in order to get the money you invested back once the CD has matured. Just to clarify, limitations and penalties for early withdrawal — taking money out before the CD matures — are not considered contingencies.
- Does the CD automatically renew? Once the CD reaches its maturity date, the bank is obligated to return your principle to you, and it should also pay you any interest earned. However you, the consumer, are also obligated to contact the bank to initiate the disbursement of your funds. Depending on how the contract is set up, the bank could automatically renew the CD if you don’t request a disbursement within a certain timeframe. Before you sign, find out what the maturity date is for that CD, and whether or not it automatically renews. If it does automatically renew, you should also find out if you can opt out of automatic renewal to avoid having your money tied up longer than anticipated.
- What are the penalties for withdrawing early? The whole point of a CD is to lock your money into an account so that it has the chance to earn interest. But, you should still plan for the possibility that you might have to access those funds in an emergency. Knowing in advance what, if any, penalties you might have to pay will save you from getting a nasty surprise later. You should also find out what if it is possible to waive the early withdrawal penalties in extraordinary circumstances, such as the death of the primary account holder.
Above all, take your time when considering your investment options. There are a lot of different ways to save money, it’s your money, and you want to invest it well. Be sure and check out some of the online banks that I think are good.
Author: KC Beavers
KC Beavers is a semi-retired entrepreneur. The subject of personal finance has always fascinated him. In an effort to not bore those around him with all his love of personal finance as much he has come here to bore all of you instead.
Great post. This explained CD in a very easy to understand manner. I clicked on the link but the interest rates are extremely low. Like the comment below said they might fit into a certain investment/saving strategy but with the interest rates this low I don't see much value in them.
I hope CD rates get back to something that is worth investing in. I had a really nice rate for 6 months but now the rate just sucks. I might as well put it in a savings account or put more in P2P. Great information for those who are not up to speed on what CD's are or how to use them. I think they fit in well with investment strategies but be careful not to just let the sit there. After awhile you will be earning pennies on a dollar.