The pros and cons of IRA CDs

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There are so many ways to prepare for retirement, it can be hard to choose.

You could contribute to a 401(k) plan or find a job that still offers a pension. Individual retirement accounts (IRAs) are also an option — if you qualify for one.

An IRA is like a bowl that can hold different types of investments. For example, you can use the money you contribute to your IRA to buy stocks or bonds which will then be held in your account.

But if you’re planning to invest your IRA contributions in a certificate of deposit, you might want to take a step back. First consider the pros and the cons of putting large portions of your retirement savings in a CD.

Risk averse? IRA CDs have benefits

There are some benefits of holding CDs in an IRA. If you open an IRA CD at a bank backed by the Federal Deposit Insurance Corp. (FDIC), up to $250,000 will be protected by the U.S. government. If your bank goes belly up, you’re guaranteed to get your savings back.

IRA CDs may also seem appealing if you like predictability. Use a calculator, and you can see exactly how much money you’ll earn over the term of the certificate, allowing you to plan your retirement date without worrying it’ll be disrupted by a massive market downturn. That’s why CDs are ideal for risk averse investors.

“Someone who’s extremely, extremely conservative and basically has zero tolerance for risk is basically the type of person that would look at a CD,” says Danny Michael, founder of Satori Wealth Management, a fee-only financial planning firm in Los Angeles.

Compared to efforts required to set up a diversified stock portfolio, investing in IRA CDs is relatively easy. It’s no different from purchasing a regular CD, but instead of transferring money into a CD from your checking or savings account, you would buy a CD using funds in your IRA.

If you’d prefer to play it safe when it comes to investing, you could even build a CD ladder by purchasing CDs with different term lengths.

Here’s another advantage of investing your IRA contributions in CDs: You won’t have to worry about fees unless you’re penalized for tapping into your account before it matures. For some investors, that’s a big deal. Retirement investing is plagued by all kinds of fees. Having investments managed by a brokerage firm can get expensive.

“Every time you place a trade, there might be a charge. And if you hire a financial adviser to manage your investments, the adviser might charge you a fee as well,” says Denise Appleby, CEO of Appleby Retirement Consulting in Grayson, Georgia.

The big drawback of IRA CDs: low yields

While a CD may be a safe place to park your retirement savings, it’s the wrong vehicle for investors trying to maximize their returns. Today’s best high-yield CDs pay around 3.5 percent APY. Historically speaking, that’s fairly low.

Retirement lasts a long time and enjoying yourself while covering increasing costs for things like medical care requires a lot of money. In order to save enough for retirement, most people need to earn a return on their investments more in keeping with a diversified basket of stocks and bonds than with CDs.

If you invest a large amount of money from your IRA in a CD, you’ll also have to worry about inflation.

“You’re losing purchasing power by investing in a CD, even if it’s a ladder,” Michael says.

The final verdict

All in all, using a short-term investment vehicle like a CD in a portfolio that’s meant for long-term growth doesn’t make sense, Michael says. It’s best to use CDs to store money for a mortgage down payment or another short-term goal.

The markets may be panic-inducing for those on the cusp of retiring, but they’re still the best chance most people have of turning retirement savings into the kind of nest egg needed for today’s long retirements. If you’re worried about fees, Michael recommends working with a fiduciary or a fee-only financial planner who will be transparent about costs.

That isn’t to say that CDs don’t have a part to play in retirement portfolios, especially as people get closer to leaving the workforce and need a lump sum of money to kick off their retirement. They just need to be grouped with a more diverse range of retirement investments that help balance all types of risk.

If you’ve decided to invest money from your IRA in a CD, make sure you understand the tax implications of doing so, particularly as you approach your maturity date.

“You’re looking at your IRA and you think, ‘Oh I have this million-dollar IRA,’ only to find out, no you don’t because some mistake that you made a year ago or two years ago resulted in a distribution that you were not aware of,” Appleby says. “Those technical rules are so critical.”