What Is an IRA CD?

You know that saving for retirement is important and you might already contribute to an employer-sponsored plan like a 401(k). Sometimes, though, an employer-sponsored plan is not enough. Perhaps your employer does not offer a plan, or perhaps you work for yourself. An individual retirement account, or IRA, is designed to help you save for your retirement without going through your employer. There are many types of IRAs. One product, the IRA CD, takes all your savings and invests them into low-risk financial instruments known as certificates of deposit.

What Is An IRA Savings Account?

To understand what IRA CD means, you first have to understand how an IRA works. An IRA is a savings and investment account that provides tax advantages for individuals who are saving for retirement. You can open one today at a regular bank. Once you've made a deposit, the money is locked away and should continue growing. At age 59 1/2, you can withdraw the money without incurring an early withdrawal penalty.

It's important to understand that an IRA is not an investment. It's more like a pot that holds all your investments in one place, and you can choose to invest the IRA funds in stocks, bonds, mutual funds or other financial instruments. As long as you are trading on your IRA, the capital gains you make on these investments will not be taxed until the money is withdrawn.

What Is an IRA Certificate vs CD?

A CD is a type of savings certificate issued by a bank to any saver who deposits money for a fixed period at a fixed interest rate. Opening a CD means you cannot get ahold of your money on demand; rather, you have to wait for a predetermined length of time until the CD matures before you access the cash (or pay a penalty). If you buy a CD using all of the funds in your IRA, then your IRA becomes an "IRA CD." It's that simple.

In return for locking your money away for a fixed period, the bank will generally give you a higher interest rate than you'd get with a regular savings or checking account. The longer the term, the higher the interest rate usually is – in investing jargon, you're forfeiting liquidity for a higher return. Since this is an IRA, the interest you earn on the CD is added to the IRA account where it grows. When the CD matures, it typically automatically rolls over into a new CD at the same rate. Upon reaching the age of 59 1/2, the entire amount of contributions, as well as interest earned, is available for withdrawal without penalty.

Example of an IRA CD

Susan is a 35-year-old marketing director who earns $90,000 per year. This puts her in the 24 percent tax bracket based on 2018 rates for single filers. She wants to start saving for retirement and heads to her local credit union to set up a traditional IRA with a $10,000 deposit.

Susan wants a guaranteed yield and is scared of exposing herself to too much risk. So, she decides to put all of the money in a CD with a term of two years and an interest rate of 2 percent compounded annually – meaning the interest is added to the investment once per year. Because Susan has opened a traditional IRA, the $10,000 contribution is tax deductible. Her taxable income drops to $80,000, automatically lowering her tax bill.

At the end of the first year, the CD will have grown to $10,200. At the end of the second year, the CD will have grown to $10,404. If Susan owned the CD outside the IRA, those gains would be taxable. But because she used IRA funds to buy the CD, none of the earnings are taxable for as long as they are sitting in the IRA account. Susan now has $10,404 in her retirement pot which will roll over into another CD if she wishes.

Fast forward 30 years, and Susan withdraws the $10,000 plus the accrued interest. Since she has now retired, her income is much lower, say $35,000 per year, which almost certainly will be taxed a lower rate than the $90,000 she earned when she was working (for example, $35,000 would put Susan in the 12 percent bracket based on 2018 rates). Though it's impossible to predict what the tax brackets will be 30 years into the future, Susan will likely pay less in taxes than she would have had to pay had she not opened up an IRA. The interest gets taxed at the lower rate, too.

Advantages: Safe, Predictable and Easy to Use

Tax advantages aside, adding a CD component to an IRA makes it a very secure way to stash your cash. CDs are insured by the Federal Deposit Insurance Commission up to $250,000 per individual. So even if the financial institution goes belly up, the chances of losing your money are virtually zero.

IRA CDs are also appealing if you like predictability. Since interest rates are fixed, you can see exactly how much you'll earn over the life of the deposit. If you wish to plan for retirement without having to worry about stock market fluctuations, then CDs are worth considering.

You might also take the simplicity of a CD into account when exploring this option. While there are many different types of CDs, all you're actually comparing are the terms and interest rates so there aren't a lot of variables to consider when choosing one. For example, you might be weighing up a 4-year CD at a rate of 1.25 percent versus a 5-year CD at a rate of 1.32 percent. You don't need a broker to help you make this type of decision and the whole thing is less time-consuming than developing an investment portfolio. Plus, you won't be paying brokerage and trade fees that eat into your retirement savings.

Drawbacks: Minimum Investments and Poor IRA Interest Rates

Predictability comes at a cost, and the major drawback is that IRA CDs provide a relatively low return when compared to stocks and other money market instruments. Today's best bank and credit union IRA rates typically cap out around 3.5 percent APY; rates between 1 and 2 percent are closer to the norm. This is not a great return for younger investors. There's a risk that your CD's growth will not outpace inflation so you're actually losing purchasing power.

Bear in mind, too, that CDs require a minimum investment. Some banks offer CDs that are geared specifically for retirement. While these products tend to pay the best rates, they often require you to deposit as much as $10,000 or $20,000 into your IRA. That naturally rules them out for savers who don't have enough to make that minimum.

Don't Forget the Early Withdrawal Penalty

If you withdraw money before the CD term is up, you'll be hit with a steep penalty. The dollar amount depends on the bank and the CD terms, but you can expect to forfeit a good chunk of the annual interest earned – for example, six months' worth of interest. Plus, since you're owning a CD inside a traditional IRA, you also have to fork out income taxes plus an additional 10 percent penalty if you withdraw funds before age 59 1/2. The bottom line is, be sure that you won't need the money for a very long time before you open this type of account.