Definition of Three-Year IRA Certificate

Do you have some spare money to save for your golden years? Are you maximizing your 401(k) contributions at work? Or perhaps you're self-employed and don't have access to an employer-sponsored retirement plan? If you've answered "yes" to those questions, then you might think about opening an individual retirement account. IRAs come in all shapes and sizes and offer multiple options for investment. One option is a three-year certificate, where you deposit your cash for a three-year term at a specified interest rate.

What Are the Different Types of IRAs?

An IRA offers an easy way to save for retirement while getting immediate tax breaks. Generally, you have the option of opening a traditional or a Roth IRA, although there are some specialized plans. With a traditional IRA, you invest pre-tax income. So if you earned $70,000 and put $10,000 into a traditional IRA account, your taxable income would be reduced to $60,00, thus lowering your overall tax bill. You pay income tax only on the withdrawals you make in retirement.

With a Roth IRA, you invest post-tax income so there's no immediate tax break. However, your withdrawals will be tax-free in retirement as long as you follow the rules. For both types of IRA, your contributions and the earnings you make on your investments are allowed to grow tax-free in your account until you withdraw them.

You must have taxable income in the form of wages or business income to contribute to an IRA, and you cannot make contributions to a traditional IRA after you reach age 70 1/2. There's no such age restriction with a Roth. You can contribute up to $5,500 across all your IRA accounts in 2018 and $6,000 in 2019. Those who are over 50 are able to add $1,000 to the contribution limit.

What Is an IRA Certificate?

Understand that an IRA is not an investment like a stock or a bond. Rather, it's a basket that holds all your investments in one place. And when it comes to investing, you have a vast array of options – IRA funds can be invested in stocks, bonds, mutual funds, real estate investment trusts and even alternative investments like gold bullion, in whatever percentages you wish. Having all these options puts you in the driver's seat and allows you to create the right portfolio to meet your personal retirement goals.

One investment you might consider is a certificate, which is shorthand for a "certificate of deposit," or CD. Despite the fancy name, this product is simply a bank deposit for a fixed length of time, such as three years. The bank can use the money you've deposited to make profitable investments and bank loans. In return, the bank will pay you a guaranteed rate of interest. The rate is predetermined and is usually higher than the rate a regular savings account earns.

Reaping the Tax Benefits

You can hold CDs inside or outside of an IRA. But if you use the money in your IRA to buy a CD, then your investment will have all the tax breaks that your IRA enjoys. In other words, the interest on the certificate will grow tax-free until you start withdrawing the money at retirement. Compared with a CD held outside an IRA, where you are liable to pay income taxes on the annual interest check, this is a significant tax advantage.

There's another advantage to holding a CD inside an IRA, and that's compounding. Every time the bank pays interest on the certificate, the money gets added to the account. You're now earning interest on the interest and none of it is taxable. Compounding plays a major role in the how quickly you build up wealth.

Leaving Your Money Invested

The length of time for a regular CD varies between 90 days and seven years. Some banks and financial institutions offer so-called "IRA CDs," which are specifically designed to help you save for retirement. These products typically have longer terms of up to 10 years. Don't let the label fool you though: you can put any CD, of any length and from any bank, into an IRA.

When the CD matures at the end of its fixed period – that will be three years for a three-year certificate – you'll need to reinvest the certificate. If you do nothing, the bank automatically will roll the money into a new three-year certificate at the same rate. This may not be the best rate on the market but don't panic, you generally have a seven-day window to choose a CD with a different term and interest rate. Be sure to check the rules with your financial institution.

If there's a drawback to three-year IRA certificates, it's that you must lock away your cash for a very long time. The IRS has strict rules in place to ensure you keep your IRA funds safe over the long term until you reach retirement.

By way of comparison, if you held the CD outside your IRA, you could cash out the certificate as soon as the three-year term was up. You'd pay taxes on the interest, but otherwise the money would go back in your pocket to use however you please. When you own a CD inside an IRA, you cannot withdraw the money before age 59 1/2 without paying a penalty and taxes. Taking the money out before then removes the tax protection, and you would immediately forfeit 10 percent of the withdrawal as an early payment penalty. So even though it's a three-year certificate, you'll be hit with some serious taxes and penalties if you withdraw the money before age 59 1/2.

Watch Out for Low Rates

CDs are safe, secure and predictable investments. They're insured up to $250,000 by the Federal Deposit Insurance Commission so there's no chance of losing your money if the bank goes belly up. Plus, you're getting a fixed and guaranteed interest rate. Some savers find it reassuring to know exactly how much return they're going to get on their investment. You'll never get such certainty with fluctuating investments like stocks.

Unfortunately, there's a price to pay for security. With IRA CDs, the tradeoff comes in the form of low yields. In November 2018, three-year USAA certificate of deposit rates were around 2.38 percent APY (that's the annual interest rate with compounded interest factored in). You'll get a higher rate if you deposit more money, and a higher rate if you commit to longer than a three-year term. But in the context of a retirement fund, these rates may not grow your fund enough to give you your desired standard of living at retirement.

Ideally, a CD should likely form only one part of your investment portfolio. If you invest exclusively in certificates, you could be missing out on higher-yielding investments and jeopardizing the growth of your retirement fund. However, every person's investment strategy is different and you may want to consult a financial professional with questions.

Where to Buy CDs

You can walk into any bank or credit union and buy a CD today without the help of a broker. Certificates generally require a minimum deposit that may be as high as $1,000, so they may not be ideal for very small funds. When shopping for a CD, be sure to compare the rate of return over the life of the certificate and not just the headline APR. There are online CD calculators that can help you compare the returns from CDs of varying deposits, terms and interest rates.