A traditional individual retirement account certificate of deposit is a conservative way to invest for your retirement. By combining the tax advantages of an individual retirement account with the security of a CD, you can protect your long-term nest egg at little to no expense. Although CDs and IRAs are a common pairing, you can usually choose other investments in your IRA to supplement or diversify your CD holdings.
A traditional IRA, often called an ordinary or regular IRA, is a retirement account designed for individual investors. If you have earned income and are under age 70 1/2, you can make contributions to an IRA. The main benefits of a traditional IRA lie in its tax structure. You can usually take a tax deduction for contributions to a traditional IRA, and your contributions and earnings grow on a tax-deferred basis. If you own a CD in your IRA, the income it generates becomes taxable only when you take it out of your IRA.
Certificate of Deposit
A certificate of deposit is essentially a short-term loan that you provide your bank. If you leave your money with the bank for the specified term — generally from six months to five years — you'll receive your money back, with interest, at the end of the period. If you sell your CD before the end of the term, you'll generally pay a penalty of a few months' interest. CDs usually pay more interest than a simple savings account, since you have to leave your money untouched for a longer period of time. Since CDs carry Federal Deposit Insurance Corp. insurance, the same as savings accounts, they can be appropriate conservative investments for retirement accounts like IRAs.
Types of CDs
Most CDs pay a fixed rate of interest, either at regular intervals or entirely upon maturity. Floating-rate CDs pay a variable interest rate, based on the movements of a reference rate, such as the prime rate. Step-rate CDs change the amount of interest paid at predetermined intervals, such as annually. Zero coupon CDs don't pay any interest in the traditional sense, but rather are sold at a discount and pay the full face value to investors at maturity.
Since CDs are federally insured, they carry little risk of nonpayment. However, all CDs carry inflation risk, which is the risk that the purchasing power of your money will decline in the future. With most CDs, you receive the same amount of principal back that you invested, along with your interest payments. However, even a small amount of inflation means the money you get back won't be worth as much as the funds you originally invested. With interest rates on CDs typically lower than you can earn on more aggressive investments, you could end up with less purchasing power than you started when your CD matures.
John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.