The Unexpected Downsides of Keeping Too Much in a CD, Even With Rates Above 5%

Image source: Getty Images

Interest rates are high right now, but they're expected to drop later this year. Certificates of deposit (CDs) are a good way to protect yourself if that happens. When you put money in a CD, the interest rate is guaranteed for the entire CD term.

Even though you can get excellent rates on CDs , there are drawbacks to putting too much of your money in them. The most well-known downside is that you'll be charged an early withdrawal penalty if you need to take your money out before your CD's maturity date. Here are a couple of other reasons to be careful about how much you keep in CDs.

You'll probably make less than you would if you invested your money

Considering what interest rates were like just a few years ago, current CD rates are pretty impressive. If you shop around for the best CD options, you could get an APY of 4% to 5% or more. In fact, CD rates are as high as they've been since 2007, according to Federal Reserve data.

But there are more profitable long-term investments out there. The stock market as a whole has an average annual return of about 10% per year, going back more than 50 years. You could invest in it through an S&P 500 or total stock market index fund.

Now, stock market returns aren't guaranteed, and they can be volatile from year to year. For that reason, CDs are better for savings that you expect to use within the next five years or so. Stock investing is better for long-term financial goals, such as building your retirement nest egg.

There's nothing wrong with making CDs part of your portfolio since they're so safe. Just make sure you're also investing in stocks to take advantage of their growth potential.

CD interest is taxable income

Interest on banking products is considered earned income, and it's subject to ordinary income taxes. This rule applies to interest you earn from CDs, savings accounts , checking accounts, and any other bank accounts you have.

People who aren't aware of this can get an unwelcome surprise at tax time when their banks send them a Form 1099-INT. If you're going to earn a large amount of CD interest, plan accordingly by setting aside some of those earnings to pay your taxes.

The tax bill is another disadvantage of putting your money in CDs compared to stocks. When you invest in stocks, you don't pay capital gains taxes until you sell. Before then, your investment can grow without any additional tax liability for you. And if you hold investments for longer than a year, you'll pay long-term capital gains taxes, which typically have much lower rates than ordinary income taxes.

Don't put all your eggs in the CD basket

CDs are a useful financial product. If you have savings you won't need for several months or years, you could lock in a great rate for it with a CD.

But just like with any other financial product, you can run into trouble if you put too much of your money into CDs. It's also important to have money in a high-yield savings account that you can access any time so you don't need to wait for CDs to mature whenever you need money. And everyone should have money invested to build long-term wealth.

We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.The Motley Fool has a disclosure policy .