Certificates of Deposit: Are They Right for You?
CERTIFICATES OF DEPOSIT: ARE THEY RIGHT FOR YOU?
Certificates of Deposit, or “CD”, is a savings account that holds a fixed amount of money for a fixed period, typically ranging from 6 months to 10 years. In exchange for this monetary deposit, the issuing bank will pay a fixed amount of interest for the agreed upon lifetime of the CD, or “term”, and will give back the initial deposit after the term is over.
Many individuals will utilize CDs for their safety, as they are federally insured up to $250,000. Additionally, individuals will utilize the interest received on their CD as a form of guaranteed income. While CDs have many positive aspects, there may be some hidden downsides that investors may not be aware of.
Investors and long-term savers alike should keep one specific goal in mind: beating inflation. Inflation increases approximately 3% year over year, so it is prudent to choose an investment or savings vehicle that matches or outpaces inflation. In our current interest rate environment, the average CD pays approximately 4%. As an example, let’s say that a depositor puts $100,000 into a 1-year CD paying 4%. Typically, a CD with a 1-year term (or less) will have its interest owed to its depositor paid out at the “maturity date”, or one year from when the CD was started. In this example, the depositor will receive $4,000 at the maturity date. With inflation tracking at approximately 3% annually, the investor will have outpaced inflation by $1,000 ($4,000 for the CD interest earnings - $3,000 for inflation on a $100,000 deposit).
While this CD would outpace inflation, the depositor may not have factored in their tax implication yet, another widely unconsidered downside to CDs. The interest received from a CD is taxed at the ordinary income rate of the depositor. If the depositor in this example was in the 22% tax bracket, they would pay $880 in tax on the CD maturity. That means that this CD would, in effect, match the inflation rate set in this example, as the investor would receive $4,000 in interest at the maturity date of the CD and pay $880 in tax ($4,000 x 22%). That means that this CD, over the course of 1 year, would outpace inflation by $120 ($4,000 - $880 - $3,000 = $120).
As we can derive from this example, if interest rates were to trend higher than 3%, the CD had a lower interest rate than 4%, or some combination of the two, the CD would be “safely losing money”, referring to the purchasing power of the initial investment. If we consider the length of time on the CD (1 year), and how it barely outpaces inflation, all the while factoring in the tax implication of the interest received from the CD, it may not be deemed to be an effective investment for the given amount of time. While CDs can be an appropriate investment vehicle for some investors due to their safety and guaranteed interest, the current interest rate environment surrounding CDs paired with the tax implication can hinder the purchasing power of the initial investment.
WHERE TO GO FROM HERE
While I have shared some broad stroke points regarding CDs that should be considered, each situation is unique, and I encourage you to have the conversations with your advisors. At Cornerstone, we use a comprehensive approach to curate a personalized plan for each of our clients to make the most out of their retirement. We want to help you live the retirement you’ve dreamed of through our fiduciary-based financial planning.
To see how Cornerstone can help you with financial planning and your retirement portfolio, call our office at (775)853-9033 or click here.
Based in Reno, NV, Cornerstone is for individuals and families looking to grow wealth, protect and preserve their life savings, and plan for the distribution of their estate in a tax-efficient manner through a tailored strategy. Schedule a time to discuss your financial goals with us.
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