Certificates of deposit (CDs) can be useful tools as you save for both short-term and long-term savings goals. But when it comes to making the most of these deposit accounts, there are some common pitfalls to avoid.
As you build your net worth with the help of CDs, don’t forget to avoid the mistakes we cover below.
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1. What is a certificate of deposit (CD)?
A CD is a type of timed savings account. As a saver, you deposit funds into the account for a predetermined amount of time at a set interest rate. At the end of the term, the financial institution will pay you the amount you invested plus accrued interest.
The predictability of a CD is attractive for many savers. You know exactly what you stand to earn by the end of the term. The catch is that you have to give up access to the funds for a set period of time.
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2. Like any bank deposit, a CD is FDIC-insured
If you work with an FDIC-insured bank, the funds you place in a CD are protected against loss for up to $250,000. With that, you don’t have to worry about risking the loss of your funds. Instead, you can plan to receive a specific amount at the end of the term.
3. How do you ladder CDs and what is the benefit?
A CD ladder is a popular strategy for savers seeking to make the most of these timed deposit products. You can build a CD ladder by opening CDs of various term lengths.
The terms will have different interest rates, and generally a longer-term CD pays the highest interest rate. For example, you might invest in a six-month CD at 1%, a one-year term at 3%, and a three-year term at 5%.
As each CD matures, you will receive the principal plus interest, creating a cycle of guaranteed income. When a CD matures, you can either open another CD with the funds to extend your ladder or take the money.
With revolving access to your money and the ability to tap into the higher interest rates typically associated with longer-term CDs, laddering makes sense for many people.
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4. Don’t buy a long-term CD if you think you will need the money
If you aren’t sure when you’ll need the money, opting for a long-term CD usually isn’t a good idea. After all, the point of a CD is to lock in a set interest rate for a predetermined period of time. For savers seeking more flexibility, a high-yield savings account might be a better fit.
5. Don’t make an early withdrawal
Most CDs come with early withdrawal penalties. The amount of the early withdrawal penalty varies from bank to bank, but in general you can expect to give up some of your interest earnings if you need to tap into your funds early.
If at all possible, avoid making early withdrawals. The decision to withdraw your funds early will come with the penalty and you lose your potential returns.
6. Don’t invest too much
A CD offers a worthwhile way to lock in set returns on your cash. In general, though, it’s not a good idea to put all of your portfolio into CDs. The lack of liquidity is a problem and you will pay a penalty if you need to take money before the term ends.
Another problem with going all in on CDs is that you could be missing out on bigger returns in the stock market. Being too heavy in CDs could mean that you are short-changing your retirement savings goals.
Make Money: 8 things to do if you're barely scraping by financially 7. Don’t forget to pay taxes on interest
Because you earn interest on your CDs, you are required to pay taxes on the interest earnings. If you roll over a CD when it matures, you still owe the IRS taxes on the interest. CDs longer than one year require you to pay taxes on the interest earned every year.
Generally, you’ll get tax form 1099-INT directly from your financial institution. But if you do not, you’ll have to request it..
If you have questions about paying taxes on your CD earnings, consult with a tax professional.
8. Don’t forget to compare rates
While it might be tempting to work with a single financial institution for all of your deposit products, this option could prevent you from gaining significant returns.
Take the time to shop around. You might be surprised to find significantly higher rates available at another financial institution. Don’t hesitate to take advantage of higher rates when you can find them.
9. Don’t forget about tax-advantaged savings options
It’s possible to open CDs within tax-deferred retirement savings accounts. If you are looking for a tax-efficient way to buy CDs, take a closer look at your tax-advantaged account offerings, like a traditional IRA.
Opting to open a CD within a tax-deferred account instead of a taxable account allows you to put off your tax liabilities until later.
Bottom line
As you take advantage of CDs as a part of your retirement planning process, thoughtful investing can make a big difference. A mix of different savings vehicles, both tax-deferred and taxable, can help supplement your Social Security in retirement.
Consulting a financial advisor when you are in mid-career can help you set goals and manage your investments so that you can be assured of a comfortable retirement.
Money tips that can work for everyone
No matter what your bank account balance is, there's always an opportunity to optimize and improve your finances. Here's a quick checklist of things you can look at today.
Focus on paying off your debt . Debt can hold you back from making progress with your overall financial well-being. Aside from cutting expenses, there are tools that can help you pay off debt faster like balance transfer credit cards and debt counseling.
Earning extra income can give you breathing room. If finances are tight, earning some extra money to supplement your income can make a huge difference. A new job is one option to consider, but if you're not ready to make a big change or already retired, a part-time side job could be a better choice.
Cut your expenses. It sounds painful and so not fun, but it doesn't have to be. Take a look at your biggest expenses because that's where you'll probably find the biggest savings. For example, auto insurance rates have been soaring so shopping around for a new insurance company can be the fastest way to cut your bill. Also, look for ways to cut your grocery bill (despite rising inflation).
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