An employer-sponsored 401(k) retirement plan typically contains a number of different mutual funds. Some plans also include other investment options such as certificates of deposit. As with any 401(k) investment, CDs grow on a tax-deferred basis. There are both pros and cons to investing 401(k) cash in CDs.
A certificate of deposit is a debt instrument. You lend money to an institution for a number of months or years in return for regular interest payments. Aside from traditional CDs, some banks offer indexed linked CDs in which your returns are based upon movements in the Standard & Poor's 500 Index or other market indices. In many instances, returns on indexed CDs are capped, which means your interest cannot exceed a certain level regardless of market performance. In such situations, you would earn less on your CD than if you invested directly in the stock market.
In theory, CDs are principal protected because the value does not fluctuate based on market conditions. Nevertheless, even within a 401(k) a CD could lose value if the issuing institution goes bankrupt. However, bank-issued CDs are insured by the Federal Deposit Insurance Corp. As of 2013, the FDIC insures bank products for up to $250,000 per account holder, per bank. With a 401(k) plan, you could acquire multiple CDs offered by different banks and receive $250,000 protection for each different bank. Neither the FDIC nor any other entity offers principal protection on non-bank issued 401(k) investment options.
Multi-year CDs are relatively illiquid because you typically have to pay penalties to cash in your account before the end of the term. This could prove costly if you retire and tap your 401(k) cash before your CDs have matured. Additionally, most banks have minimum deposit requirements for CDs and rates on CDs are often tiered, which means you get the best rates when you deposit large sums of money. As of 2013, your 401(k) annual contributions cannot exceed $17,500. These restrictions might cause you to miss out on the best rates.
A 401(k) CD may appeal to you if you are risk adverse and unwilling to invest in mutual funds. However, risk comes in many varieties, and CDs expose you to interest rate risk. Over a long time, inflation often outpaces the rates of interest available on fixed instruments such as CDs. Your principal remains intact but your spending power decreases as prices for commodities and consumer goods continue to rise. Many investors hold 401(k) plans for several decades, in which case inflation risk is as much of a foe as principal risk.