3 Lesser-Known Drawbacks of Opening CDs

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There's a reason so many people have been rushing to open certificates of deposit (CDs) this summer. CD rates are sitting at their highest level in decades -- so who wouldn't want the chance to earn a risk-free return in the ballpark of 5%?

But while it's easy to see why CDs might appeal to you, you should know that there are certain pitfalls you might encounter if you decide to open one. Here are a few less-obvious drawbacks of putting money into a CD.

1. They don't always pay more than savings accounts

The appeal of CDs is generally twofold: You can snag a higher interest rate on your money than with a regular savings account , and that rate is guaranteed until your CD matures.

But while a CD might offer a higher interest rate than a regular savings account, that doesn't mean you'll earn more interest from it. And the fact that CD rates are set in stone could work against you if rates are on the rise.

Say you open a 12-month CD at 3% at a time when a high-yield savings account is only paying 2.5%. At first, the CD reads like the better deal.

But what if you lock in that CD, and then a month later, interest rates start climbing? By the three-month mark, you may find that savings accounts are paying 3.25%. But gosh darn it -- now you're stuck earning just 3% on your CD, and you can't get your money out without facing a penalty (which is usually the case).

Of course, right now, this isn't an issue. Interest rates aren't expected to rise during the second half of 2024. If anything, they're expected to fall. But the above risk definitely applies during periods when interest rates are in flux and have the potential to increase (for example, during periods of inflation when the Federal Reserve may be more hasty with rate hikes).

2. You could end up with a major savings shortfall in the long run

The idea of earning a risk-free return on your money may seem nice -- especially when you can lock in a CD at 5%. But in the long run, tying up money in CDs could lead to a savings shortfall. That's because the stock market has a history of outperforming CDs.

Over the past 50 years, the stock market's average annual return has been 10%. That's double the 5% many CDs are paying now. And we all know that today's CD rates are also considerably higher than they normally are.

To show you how sticking with CDs in the long run might hurt you financially, let's say you put $5,000 into CDs that pay you 3% a year over the next three decades. In 30 years, your $5,000 will have grown into about $12,100.

But if you put that same $5,000 into a stock portfolio that delivers a 9% annual return, which is just below the stock market's average, in 30 years, you'll have about $66,300. So in this example, sticking with CDs leaves you about $54,000 short.

3. You could end up owing the IRS money if you earn a lot of interest

The IRS is entitled to a piece of pretty much any income you get your hands on. And that includes interest income.

The fact that CD rates are high right now is good in theory. But if you don't plan carefully, you might end up owing the IRS a pile of money next April. You may want to make estimated tax payments this year if you have a lot of money earning 5% in CDs.

In fact, you should know that the interest you earn from CDs (and savings accounts) is taxed as ordinary income. That means you're taxed at the highest rate you're subject to.

If you want to avoid having to pay yearly taxes, you may want to consider investing your money instead. If you choose an individual retirement account (IRA) , your investment gains are tax-deferred, which means you don't pay anything to the IRS until you start taking withdrawals from your account.

And even if you choose a regular brokerage account , you won't necessarily have to pay taxes to the IRS on your investments every year. Taxes will only come into play if you collect dividends (and not every stock pays them) or if you sell stocks at a profit (which you may not do and can specifically avoid doing for the purpose of not owing more tax).

CDs are a great way to earn money without taking on the risk that comes with investing. And it's easy to see why you'd want to open a CD now, given that rates are so high. But it's important to be aware of the drawbacks of CDs so you can make the best decision for your money.

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