What Is the Difference Between an IRA & a CD?

What Is the Difference Between an IRA & a CD?

Individual retirement accounts are strong savings vehicles for one reason: they have a tax edge over other types of savings accounts. As you put money into an IRA, you don't pay taxes on the fund or the returns it is making. Crucially, an IRA is not an investment – it's a vehicle that you can put investments into. One such investment is the CD or certificate of deposit, which many risk-sensitive savers choose to hold inside or outside an IRA.

What Is an IRA?

Individual retirement accounts allow you to invest money for the future solely through your own contributions. Like an employer-sponsored plan, the hope is that you'll contribute enough to your account, and the fund will grow enough, to satisfy your spending needs at retirement. Uncle Sam gives you a helping hand in this respect, in the form of tax deductions.

The two most talked-about IRA types are the traditional and the Roth IRA. With a traditional IRA, your contributions are made with pre-tax dollars, meaning you can deduct some or all of your contributions on your tax return. Taxes are payable when you take the money out at retirement. With a Roth IRA, you pay tax as you normally would when you make contributions to your account. But you can withdraw the money and investment earnings tax-free at retirement.

If you suspect you'll be in a lower tax bracket when you retire than when you're making contributions, a traditional IRA can be a good option. If it's the other way round, then you might think about opening a Roth IRA.

What Is a Certificate of Deposit?

A certificate of deposit, or CD, is a type of savings deposit where you lock down your money for a pre-set term, typically ranging from one month to several years. In exchange, the bank agrees to pay a predetermined rate of interest for the duration of the term. Most institutions will offer higher interest rates for larger deposits and longer terms. Rates are generally better than you'd get with a regular savings account, and the interest is part of your taxable income.

You can purchase a CD directly from an issuing bank or credit union. They're available in various denominations, for example, $1,000, $5,00 or $10,000.

What the Difference Between an IRA and CD?

While both vehicles can be used to help you save for retirement, they are two completely different products. Primarily, an IRA is an investment account – you can invest in lots of different products within an IRA, from stocks and bonds to real estate investment trusts. A CD is simply a savings account – you're depositing money in the bank for a certain length of time in exchange for a specified interest rate.

That said, you often hear the terms "IRA" and "CD" together. That's because a lot of investors choose to purchase CDs using the funds available in their IRA. Some banks offer special "IRA CDs" which are designed for retirement savings. These certificates tend to have longer terms than regular CDs, and receive all the tax advantages that are associated with a traditional or Roth IRA.

CD Vs IRA Means Short-Term Vs Long-term Investments

A major difference between an IRA and a CD is the length of time your money grows. CDs always have a predetermined time span, such as six months, one year or three years, but it's rare to find a certificate that lasts longer than five years outside an IRA. So, they are short- to medium-term investments.

An IRA, on the other hand, is specifically designed to help you save for retirement. Ideally, you will keep making regular deposits in the account, each month or each year, until you reach retirement age. You cannot make withdrawals until you reach age 59 1/2 without paying a penalty, so you're looking at a much longer-term investment.

CDs Pay a Guaranteed Interest Rate, But the Rate May be Lower

CDs pay a specified interest rate throughout the term of the CD, which means it's extremely easy to calculate how much return your deposit will make. If you're looking for certainty and predictability from your investments, then CDs may be an ideal choice.

IRAs do not come with a guaranteed rate of return because they are not an investment. Rather, you use the fund to invest in stocks, bonds, mutual funds – even CDs. Each of those investments will have its own rate of return and your returns may be quite volatile, especially if you're investing in stocks.

As with all investments, the higher the risk, the greater the potential returns. The major upside of an IRA is that you can diversify your investments to give you the best possible yield further down the road. A two-year CD, by contrast, is capping out around 2.9 percent APR in November 2018. If you rely solely on CDs to provide for your retirement, there's a risk that you will not create enough wealth to meet your retirement goals.

CDs Are Taxable, IRAs Are Tax-Deferred

Taxes are a drag on your investment returns and that's what you're facing with a CD. If you place money with a bank and they pay you interest on it, and the CD sits outside of an IRA, then you have to pay taxes on the rate of return. So, it's not a tax-efficient savings vehicle.

An IRA, by contrast, grows tax-free until you withdraw the money in retirement. Buying a CD within an IRA means you get the benefit of these tax savings. Every year when the bank pays interest on your IRA certificate, the money gets credited back to your IRA fund so it earns compound interest – that's interest on your interest. Compounding is important because it allows the money that you have in your IRA to grow even faster.

IRAs Can be Risky, CDs Are Virtually Risk-Free

Most certificates of deposit are insured by the Federal Deposit Insurance Corporation for up to $250,000 per individual, per bank. So even if the bank that issued the certificate went bust, your money would be saved.

IRAs are not insured so in the rare event that your brokerage firm failed, you could lose the entire value of your investment. Plus, there's risk inherent in the investments themselves, especially if you are playing the stock market. Investment advisers can help you select a portfolio that meets your preference for risk versus reward.

IRAs Have Contribution Limits, CDs Do Not

You can invest as much as you like in a CD, subject only to the bank's restrictions, and you can have as many CDs as you like. With an IRA, you're limited to $5,500 per year in contributions or $6,500 if you're aged over 50 in 2018. In 2019, those limits will rise by $500. The limit applies to all of your IRAs in total, including traditional and Roth accounts. You can't contribute more by opening multiple IRA accounts.

Both Have Early Withdrawal Penalties

You face an early withdrawal penalty for taking money out of a CD before its term is up, or for taking money out of an IRA before you turn 59 1/2. The CD penalty varies from bank to bank but usually, it will amount to a few months' worth of interest. The IRA penalty is fixed at 10 percent of the withdrawal. This means that neither investment is a good idea if you need to access the money right away.

You can generally avoid early withdrawal penalties for an IRA if you're purchasing a first home, you need to pay medical bills, or you have disability-related expenses. The rules are complex; follow the chart on the IRS website for guidance on this issue.