High savings rates have pushed certificates of deposit (CDs) into the limelight in recent years. When rates were low, CDs were a relatively underused savings workhorse. But when top CD rates soared to 5% or more, they became savings superstars.
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CDs are popular with retirees who want a low-risk way to earn predictable returns, particularly as you can buy CDs through top brokerages as well as banks. You can even put CDs into your individual retirement account (IRA).
But CDs are only useful in certain scenarios. Even before rates started to fall, they weren’t a financial magic bullet. Here are three reasons to park your cash elsewhere.
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1. Rates are falling
The Federal Reserve just cut its benchmark interest rate for the first time in over four years. Sure, that 0.5% cut alone won’t make that much difference to your CD earnings. But it won’t just be 0.5% — this is likely the first in a series of rate cuts. We can expect to see rates on savings accounts and CDs fall steadily in the coming year or two.
Some argue that falling rates are all the more reason for retirees to lock in relatively high rates while they’re still available. That’s understandable. Just be aware that any money you lock into a CD is money you can’t use for other things.
If you haven’t saved as much as you’d hoped for your retirement, that’s money that isn’t earning higher returns through investments. Buying stocks carries more risk than CDs, but stock investments can also seriously outperform them.
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2. You have to pay taxes on CDs
The IRS considers any CD interest of more than $10 as taxable income. Unless you’ve put your CDs into a tax-advantaged account, such as an IRA, your interest payments will be taxed at the same rate as your salary or other income.
Let’s say you have $2,000 in a 3-year CD that pays an APY of 4.5%. You’d earn $90 in annual interest. If you’re in the 22% tax bracket, you’d pay almost $20 in tax each year. That essentially lowers the APY by almost 1%. You’d still be ahead of inflation, but not by much.
CD interest taxes work differently from those on long-term investment gains. Firstly, if an investment increases in value, you only pay taxes when you sell the asset and realize those gains. Secondly, if you hold the asset for longer than a year, you’ll pay long-term capital gains tax rates, which will likely be lower than your income tax rate.
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3. Your money is tied up until the end of the CD term
For the most part, when you put money into a CD, you commit to leaving it alone. You’ll have to pay an early withdrawal penalty if you want to get at it before the end of the term. That means CDs aren’t a great place to put money you might need to access at any time, such as your emergency savings.
The Fed’s decision to cut rates means we’re in for a period of change, which can bring opportunities. But it’s harder to jump on new — potentially more lucrative — options if your money is tied up for long stretches of time.
Building a CD ladder can help mitigate this risk. This involves dividing your money up and putting it into several CDs of different lengths so chunks of your money aren’t locked away for as long. Even then, CDs are relatively illiquid and don’t give you a lot of wiggle room.
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Forget about CDs — there are better places to put your money
It’s easy to understand the attraction of a low-risk savings account that pays predictable returns, particularly if you’re retired and don’t want to take unnecessary risks with your nest egg. But it’s really important that your retirement savings don’t stagnate. This can happen if you put too much into CDs.
Here are some other things to do with your money:
- Invest in bonds: Now that interest rates are falling, bonds are gaining traction again. Bonds have had a rough few years, but they’re a great alternative to CDs. They can provide a fixed income and often perform well when rates are going down.
- Pay down high-interest debt: If you carry a balance on your credit card, you may be paying upward of 20% in interest. That beats every CD on the market, as well as many other investments.
- Buy dividend-paying stocks: Dividends are a way for companies to share their profits with shareholders. Not only can those payments be a good source of income for retirees, but the stocks themselves may also appreciate in value.
It isn’t easy to structure your retirement portfolio — and there’s no single “right” answer. CDs can play their part, but diversification is crucial so that you’re not dependent on any one investment. The rest depends on your needs, risk tolerance, and wider financial plan.
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