How Safe are CDS

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Certificates of deposit which are commonly called CDs have become one of the most popular retirement investments around. These vehicles have become so popular because they are very secure and extremely to access. Despite their supposed safety there are some risks asked with these products that you should be aware of.

 

So What is a CD Anyway?

A certificate of deposit is actually a special type of bank account that functions more like a bond than a traditional savings. Basically you agree to put a specific sum in one and the bank will pay you a higher rate of interest than a normal savings. In exchange for this you sign a contract that obligates you to pay a penalty if you take the money out before the CD matures.

 

Like a bond such a certificate pays a higher rate of interest at a certain date. The advantage to this arrangement is that you get a higher rate of interest on an FDIC insured investment. A CD account at a bank insured by the Federal Insurance Corporation or FDIC is guaranteed by that agency. That means the FDIC will pay you back if the bank collapses.

 

The benefits to this arrangement are obvious you receive a higher rate of interest and more security. There are some drawbacks to it that you should be aware of. In particular you should realize that CDs are not designed to be a long-term investment.

 

How Inflation Destroys CD Income

The big danger to CDs comes from inflation which can quickly destroy the value of cash in such an account. The average certificate of deposit pays an interest rate of around 1.5% while the average rate of inflation fluctuates between 2% and 4%.

 

That means if Cletus left $10,000 in CDs for four years he would make $150 a year or $600 in total from interest. Yet poor Cletus wouldn’t make any money because of inflation. If the rate of inflation was 2% a year it would eat up around $200 of the value of his CDs. That means Cletus would actually be losing around $50 a year even with interest. So at the end of four years Cletus would actually be $200 poorer. As you can see it would make no sense for Cletus to keep his retirement nest egg in CDs because he would lose money.

 

How to Use CDs as an Investment

Even with inflation a certificate of deposit is not necessarily a bad investment. It is simply designed as a short term vehicle to park money until you find another use for it.

 

Let’s say Roscoe made several thousand dollars by selling an old car he owned. Roscoe’s job situation is uncertain so he thinks he might need some of that money in the near future. He could put it in a CD and wait to see what happens. If Roscoe found a better job with a good salary he could wait until the CD matured and put those funds in a retirement investment such as a deferred annuity.  If Roscoe lost his job and needed the cash he would have the money.

 

There’s a big reason why Roscoe should put that money in something like an annuity. A certificate of deposit and any interest it earns is subject to your normal rate of income tax. Any money you keep in CDs is going to increase the size of your federal tax bill. Retirement investments such as annuities, insurance policies and IRAs are tax-deferred so you will not have to pay taxes on funds in them until you take the money out. Any interest or other returns earned on funds in one are also tax deferred.

 

Now there is a time that you should leave funds in instruments such as CDs. If you are under 59½ years old you will have to pay a 10% tax penalty on withdrawals from retirement instruments in addition to your normal income tax. Therefore you would be wise to leave funds that you might need right away in an instrument such as a certificate of deposit.