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Certificates of deposit (CDs) have become a lucrative savings vehicle for investors looking to earn high returns, with some paying 5% or more (see some of the highest paying CDs you can get now here).
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With rates like that, CDs likely have a place in your financial life. If you have excess cash that you anticipate needing in the short-term, say for a wedding or house down payment that will happen in a year or two, consider investing that in a CD.
“CDs make a good place to invest part of your overall asset allocation,” says certified financial planner Jim Kinney at Financial Pathway Advisors, adding that “a typical moderate asset allocation might be 60% stocks, 35% bonds and 5% cash. CDs are a great place to put the cash part of that allocation.” Over the recent years of low interest rates, many investors neglected the idea of allocating part of a diversified portfolio to cash. “With two-year CD yields over 5%, it makes perfect sense right now,” says Kinney. (See some of the highest paying CDs you can get now here.)
But just because they’re paying a pretty penny — you can see MarketWatch Picks list of some of the highest-paying CDs here — doesn’t mean they’re the right place to park all your cash.
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What not to use a CD for
Although there are many good reasons to buy a CD these days, there are some instances in which you should avoid them altogether. “You should not use a CD for your emergency savings,” says certified financial planner Alvin Carlos at District Capital Management. Because CDs effectively tie up your money for anywhere from three months to five years, you don’t want to put any funds you’ll need access to in a position where you’ll be penalized for accessing them. Indeed, should you need to touch your emergency fund before a CD matures, you’ll have to pay a penalty and likely be forced to withdraw the remaining funds left in the account.
That’s not all. “You also don’t want to use a CD for long-term investments, if you don’t want to leave money on the table. Stocks are the preferred vehicle for long-term investments given its higher potential for growth,” says Carlos. Adds certified financial planner Eric Ross at F2 Wealth: “I also don’t recommend CDs be used as a long-term investment strategy. They’re great for needs ranging from a few months to a few years but anything beyond that and there are likely better options.”
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Indeed, the stock market has historically returned about 6.5%-7% a year, according to McKinsey data. “Inflation erodes the purchasing power of a CD over time, so ideally, if your risk tolerance can handle it, put longer term money in a diversified portfolio of good quality stocks and shorter-term money into CDs,” says certified financial planner John Piershale of John Piershale Wealth Management.
Another thing to avoid when it comes to CDs is putting amounts in over the FDIC insurance limit. Standard deposit insurance under FDIC-insured accounts is $250,000 per depositor, per bank, for each account ownership category.
That said, affluent people may want to look at alternatives. “People in a high tax bracket may want to at least investigate what tax-free bonds are paying, as CD interest is taxed at your highest marginal income tax bracket,” says certified financial planner John Piershale of John Piershale Wealth Management.
As stated above, for higher income households, CDs have unfavorable tax treatment compared to other alternatives. “The interest from brokered CDs is taxed at ordinary federal and state income tax rates, so if you’re buying a CD in a taxable account, outside of a retirement account ike an IRA, you may want to compare the tax liability or the tax equivalent yield of a CD and compare it to that of a Treasury bill or a municipal bond which are taxed at lower rates,” says financial planner Matt Hylland at Arnold and Mote Wealth Management.
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Specifically, Hylland says today you can find a one-year brokered CD with a rate of 5.3% and the one-year Treasury bill has a yield of 5.23%. “If you are in a state or local municipality with a higher tax rate, it may be advantageous to use the one-year Treasury bill since it is not subject to state or federal taxes,” says Hylland.
