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Certificates of deposit (CDs) and individual retirement accounts (IRAs) are two types of accounts you can use for savings, each with its own set of benefits and potential drawbacks. A CD is a type of high-interest savings account, while an IRA is a tax-advantaged retirement account. Learn how these accounts work and when it makes sense to use each.
What Is a CD?
A CD is a type of savings account offered by banks and credit unions. CDs are time deposits, meaning you agree to leave your money in your account for a specified period of time. In return, you earn a predetermined rate of interest, often higher than you'd earn on a traditional savings account. If you withdraw your money before your CD's term is up, you'll forfeit a portion of your interest as a penalty for early withdrawal.
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Pros and Cons of a CD
CDs can be an excellent place to park your money if you don't need regular access to it and you want a high interest rate. Here are a few pros and cons.
- Compared to regular savings accounts, CDs pay relatively high interest.
- CDs are widely available from banks and credit unions.
- CDs are insured up to $250,000 per depositor by the Federal Deposit Insurance Corp. (FDIC) if they're kept at a bank or the National Credit Union Administration (NCUA) if they're kept at a credit union in case the financial institution fails.
- Because a CD's annual percentage yield (APY) is fixed, you'll earn the agreed-upon interest even if rates drop during the CD's term.
- CDs have a shorter time horizon than IRAs: They can be better for goals like saving for a down payment, where you don't need the money immediately but don't want to wait until retirement to access it.
- To avoid forfeiting interest, you must keep your money in the CD, untouched, for the agreed-upon term.
- The interest you earn from a CD is taxable.
- You may not see the same returns you would on an investment in stocks, bonds or mutual funds, though you also won't have the same risk of loss.
What Is an IRA?
An IRA is a tax-advantaged account that helps you save for retirement. There are different types of IRAs, including SEP-IRAs and SIMPLE accounts for small businesses and self-employed people. For the purposes of this article, we'll focus on the two most common types of IRAs: traditional and Roth IRAs.
Traditional IRAs are funded with pre-tax dollars. This means you can deduct the amount of your contribution from your taxable income. You don't pay taxes on earnings as long as the money stays in your IRA account. When you withdraw the money, you'll pay regular income taxes on the full withdrawal.
Roth IRAs are funded with after-tax dollars, so you don't get to deduct your contributions on your taxes. However, money in a Roth IRA grows tax-free, and you don't pay taxes on qualified withdrawals.
Pros and Cons of an IRA
The government offers tax benefits on IRA accounts as an incentive to save—and to help maximize growth in retirement accounts. As a trade-off, your IRA money isn't easy to access (or raid) until you reach retirement. Here are a few things to consider about IRAs.
- Traditional and Roth IRAs each have tax benefits that can help you maximize your retirement savings by reducing your tax burden.
- You can invest IRA funds in a wide range of investments: stocks, bonds, mutual funds, money markets and even IRA CDs.
- Penalties and taxes on withdrawals can discourage you from making early withdrawals and depleting your retirement funds.
- The IRS sets an annual limit on IRA contributions. For the 2023 tax year, contributions are limited to $6,500 with an additional $1,000 catch-up contribution if you're over 50.
- To contribute to a Roth IRA, you'll also have to fit within IRS income limits.
- An early withdrawal penalty may apply if you withdraw your money before you're 59½, with some exceptions such as for hardship or buying a home.
- Unlike CDs, which have guaranteed returns, results will vary depending on the investments you make in an IRA.
Which Should You Choose?
It's entirely possible that you'll have both a CD and an IRA during your lifetime. A more immediate question is, which type of account works for you right now? To decide where to allocate funds, match up your situation against the following considerations.
CDs are a safe place to keep your savings. IRAs are for retirement.
CD terms typically range from a few months to a few years. Money kept in an IRA is meant to stay there at least until you reach age 59½—longer if you retire later.
The interest you earn on CDs is taxable as regular income. Both traditional and Roth IRAs have tax advantages.
You can deduct contributions to your traditional IRA from your taxable income, and money grows tax-deferred as long as it stays in your account. Roth IRA contributions are not deductible, but both earnings and withdrawals are tax-free as long as you meet IRS requirements.
CDs offer guaranteed returns, even in a declining interest rate environment. CDs are also insured by the FDIC or NCUA in case of bank or credit union failure.
The risks associated with an IRA largely depend on how you invest your funds. Generally speaking, returns on stock, bond and mutual fund investments follow the markets, which means greater unpredictability.
CDs typically pay more in interest than regular savings accounts. However, returns on a CD don't always match the potential returns you might see from investments made in an IRA, especially over the long term.
Again, returns on investments will vary based on the markets and your investment choices.
Deposits and Contributions
Here, both types of accounts have their pros and cons. Although some CDs let you add on funds after you open them, most CDs are geared toward lump-sum deposits. If you want to make frequent deposits, for instance by setting aside part of each paycheck, a CD might not be the right vehicle for you.
Making frequent contributions to IRA accounts usually isn't a problem. On the other hand, your annual contribution is limited to $6,500.
Both CDs and IRAs restrict your ability to withdraw funds. An IRA often charges an interest penalty for withdrawing your funds before your term is up. If you withdraw funds from your IRA before you reach age 59½, you may have to pay a 10% early distribution penalty to the IRS, in addition to taxes if you have a traditional IRA.
Sometimes, your ideal choice is neither a CD nor an IRA. Among the many account types you have to choose from, these may fit when a CD and an IRA aren't quite right:
- Consider a high-yield savings account or money market account if you want to have access to your funds at any time—or you want to make deposits whenever you like.
- Check out a 529 educational plan or a health savings account. These tax-advantaged accounts help you target non-retirement financial concerns (education savings and health care expenses, respectively).
- Tap into your employer's retirement plan, especially if you have access to matching funds. Bonus: You may be able to contribute to both your employer's 401(k) and an IRA if you meet IRS qualifications.
The Bottom Line
Both CDs and IRAs can help you reach long-term savings goals. Choosing the type of account that works best for you means looking at your current circumstances, future goals and interim needs, such as tax savings, guaranteed returns or flexibility. Whether you choose a CD, an IRA or another type of savings account, saving for the long term is a worthy goal that can help stabilize your finances—and your financial outlook.