What is an IRA CD?
So what is an IRA CD?
Abbreviations often cause confusion, but even more so whenever these two get together.
But don’t worry, we’ve got you covered.
In this article, we’ll break down everything you need to know about IRA CDs.
We’ll tell you what they are, how they work and let you know whether they deserve a spot in your investment portfolio.
What is an IRA CD?
While these five letters often cause plenty of confusion, an IRA CD is simply an investment product that’s held within a US registered investment account.
Let’s break it down.
What is an IRA?
An IRA is an individual retirement account (IRA) where you can hold various investment products. They can be stocks, bonds or – in this case – a certificate of deposit (CD).
There are three types of IRA accounts:
- Traditional IRA
- Roth IRA
- Rollover IRA
Traditional IRA’s are most popular.
Here, accounts are officially registered in your name and all contributions are considered tax deductible.
For example, if you contribute $10,000 to an IRA account and reside in a 30% tax bracket, you’ll save $3,000 in taxes that year.
Secondly, if you contribute money when your tax rate is high (30%) and withdraw the money in retirement when your tax rate is low (say 20%) – you earn a positive spread there as well.
The greatest benefit however, is tax deferral.
With a traditional IRA, all capital gains and dividends earned are tax-exempt until you make withdrawals from the account.
With a Roth IRA, you don’t receive a tax deduction, however all capital gains and dividends grow tax-free and can be withdrawn tax-free.
Now for a rollover IRA.
It’s called a ‘rollover’ because the account is used to transfer funds/assets from an employer-sponsored retirement account – such as a 401k – into an individual IRA account.
What is a CD?
A CD – short for a certificate of deposit (CD) – is a savings product offered by most banks, credit unions and mortgage lenders.
They have fixed interest rates and fixed maturity dates. Most importantly, CD’s are insured by the Federal Deposit Insurance Corporation (FDIC) up to a maximum of $250,000 per person.
So how do certificate of deposit work?
Similar to a US Treasury, a CD is structured where you lend money to an institution for periods ranging from a few months to several years.
CD’s with maturities less than one year are considered ‘money market’ CDs.
Now, the reason CDs are similar to US Treasuries is because of the FDIC insurance factor.
Since balances are federally insured, the investment is similar to lending money to the US Federal Government.
Last is tax implications.
For CDs held outside of IRA accounts, interest earned is considered income and you report it as part of your taxable earnings each year.
What is an IRA CD? | Conclusion
As you may have guessed, an IRA CD is simply holding a certificate of deposit (CD) within your individual retirement account (IRA).
Now what causes some confusion is, banks can offer special IRA CD rates.
In reality, the product is no different than any other CD, however banks do this because IRA accounts are used by long-term investors, which requires them to lock up their money for longer periods of time.
The main benefit – outlined above – is the tax benefits of IRA accounts.
If you purchase a CD in a non-registered account, you have to declare all interest as income and pay tax on the earnings.
However, if you hold the CD in an IRA account, all interest is tax deferred (traditional IRA) or tax-free (Roth IRA).
IRA CD Rules
Like any other registered investment account, there are rules you need to follow when purchasing a CD.
IRA CD Withdrawal Rules
When you invest within an IRA, you can’t withdraw money from the account – without penalty – until the age of 59 ½.
The IRA penalty is 10% per withdrawal, so if you cash out $10,000 – you’re looking at an extra $1,000 in fees.
Other IRA CD Rules
Like many other registered accounts, IRA’s come with contribution limits.
As of 2019, the annual contribution limit is $6,000 – which is an increase from $5,500 a year ago.
It’s important to note though, if you exceed the annual contribution limit, the IRS can levy a fine.
However, if you fix the mistake before you file your tax return, it’s possible to avoid the penalty.
What are the IRA CD advantages?
Like we mentioned above, there are significant benefits to purchasing a CD within an IRA.
Some advantages include:
- Receiving a tax deduction with a traditional IRA
- Receiving tax deferred or tax-free interest
- Zero risk because CDs are FDIC insured
- Ability to tailor CD maturities to your specific time horizon (30 days to several years)
- No trading commissions required to buy or sell a CD
- Low portfolio volatility compared to stocks, bonds or other securities
What are the IRA CD disadvantages?
Like most things in life, there are two sides to the coin.
Some disadvantages include:
- Early withdrawal penalties prior to age 59 ½
- IRS penalties for over contributing
- Low interest rates make it hard to outpace inflation
- Slow capital growth for a portfolio that consists mainly of CDs
Who is an IRA CD best for?
IRA CDs are best for mature investors or retirees.
In the real world, there is always a trade-off between return and risk.
To generate a high return you risk losing capital in the process.
However, when you’re young, you have plenty of time to make up for portfolio losses.
Retirees – or those near retirement – don’t have that luxury.
Many require stable and reliable income streams and can’t afford significant drawdowns to their portfolio.
Thus, IRA CDs are best for mature investors and should be considered within the context of their overall portfolio.
What Banks offer the best IRA CDs?
Considering it’s a rather vanilla investing product, IRA CDs are often very similar across institutions.
Despite that, we know a few banks that offer high-quality products and provide great service in the process.
As an online alternative to traditional brick-and-mortar operations, Ally Bank offers IRA High Yield Certificate of Deposit (CD) products with higher interest rates than most of its competitors.
3-month CDs start at 0.75%, 12-month CDs offer 2.75% and 5-year CDs offer 3.10%.
As well, interest compounds daily and all deposits are FDIC insured up to $250,000.
Like Ally Bank, Capital One offers extremely competitive interest rates as well.
6-month CDs start at 0.60%, 12-month CDs offer 2.70% and 5-year CDs offer 3.10%.
There are also no minimum balances required and all funds are FDIC insured up to $250,000.
Bank of America
Consistent with its two rivals above, Bank of America IRA CDs offer similar – although slightly lower – interest rates.
As part of its promotional offering, 13-month CDs offer 1.98%, 25-month CDs offer 2.08% and 37-month CDs offer 2.28%.
And like Capital One, there are no minimum balances required and all funds are FDIC insured up to $250,000.
What is an IRA CD? – Summary
While many investors are confused by the terminology, an IRA CD is simply a certificate of deposit (CD) that’s held within an individual retirement account (IRA).
While a CD investment can be held in virtually any account and an IRA can hold virtually any investment, combining the two results in an IRA CD.
Like we mentioned, there are plenty of benefits to owning an IRA CD – with tax deductible contributions and tax deferred interest at the front of the line.
However, a portfolio that holds only IRA CDs will have slower capital growth, so they’re best used in combination with other traditional investments like stocks and bonds.