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With tax day approaching, you might be looking around for extra deductions.
Fortunately, there is a last-minute incentive that you may be able to claim today: A tax break for traditional individual retirement account (IRA) contributions.
Whether you qualify for a deduction depends on multiple factors, including your filing status, modified adjusted gross income and access to an employer-sponsored plan, like a 401(k). As long as it’s below the annual contribution limit, any money you place in a traditional IRA can potentially be tax deductible.
You get to pick the investments that will be held in your IRA. If you’re eligible for the IRA deduction, that’s the case regardless of whether you keep your IRA contributions in certificates of deposit (CDs) or other investment vehicles.
Holding CDs in an IRA
Holding CDs in an IRA could be worth considering, particularly if you’re risk averse or you’re nearing retirement and need a short-term account to tap into. Otherwise, it’s probably best to invest your IRA contributions elsewhere.
“You’re obviously talking about a cash account that has limited growth potential and you have to look and see whether that makes sense,” says Matt Etzler, founder of Etzler Financial Advisors in Red Bluff, California.
How could having CDs held in an IRA be a bad move for some investors? In a low-interest-rate environment, you’ll end up with a low average yield, says Chantel Bonneau Stewart, a wealth management advisor at Northwestern Mutual in San Diego.
Putting some of your retirement savings into investments that are less risky may seem wise, especially if you’re fearful of an economic slowdown. But whether you decide to keep CDs, stocks or mutual funds in an IRA should depend on your long-term financial goals and tolerance for risk, not your emotions.
“You always have to look at your risk tolerance,” Stewart says. “That’s what should dictate if you choose to be in the market or you choose to have a CD or you choose to split those dollars.”
Choosing the best IRA CD
Shopping for a CD that you’re planning to hold in an IRA is just like looking for a standard CD. You’ll need to consider both the yield and the length of the CD term. In a rising rate environment, you may want to consider a CD with a term no longer than one year. This ensures the money is freed up soon so it can be reinvested if rates climb higher.
Look for a bank that insures deposits up to the limit for each account holder for each qualified account type ($250,000).
Finally, decide whether you’re looking for a bank that only appeals to you because of its high-yield CDs or an institution that meets several of your financial needs, like offering low rates on mortgages and advanced digital features.
Taking taxes into consideration
In addition to potentially getting the IRA deduction, having a traditional IRA means you won’t pay taxes on contributions or any interest you earn until you withdraw it in retirement. In contrast, if you opened a Roth IRA, you wouldn’t qualify for a deduction, but your distributions in retirement would be tax-free.
Whether you choose CDs or mutual funds held in an IRA, it’s prudent to act cautiously when moving funds in and out of a retirement account. If you withdraw money from a traditional IRA CD before the end of the term and you’re under age 59½, it’s necessary to pay income taxes and a 10 percent penalty (unless you’re exempt under an IRS rule). On top of that, you could be penalized by your bank or credit union for making an early withdrawal from the CD.
When your IRA CD matures, request that your bank directly transfer those funds into another investment held in your IRA. Avoid a rollover, which gets reported to the IRS and must be deposited to the receiving account within 60 days, says Denise Appleby, CEO of Appleby Retirement Consulting in Grayson, Georgia.
“Never do a rollover where you take money out and bring it to another bank because you can only do that once a year,” IRA distribution expert Ed Slott says. “And if you’re not keeping track, the whole thing could end up being taxable.”