Yahoo Finance Why IRA CDs Can Be Useful for a Part of Your Portfolio
A bank certificate of deposit is often overlooked by investors. CDs are known to be useful for saving, but they're often looked down upon for investing. Yes, an investment portfolio of only CDs is probably not appropriate for many investors. However, it can make sense to include CDs for at least a portion of one's portfolio.
If an investor decides to include CDs, holding them inside an individual retirement account can be a smart strategy.
The traditional asset classes of an investment portfolio include stocks, bonds and cash. The percentage of each asset class (asset allocation) depends on an investor's time frame, risk tolerance and goals. Investors with short time frames and low risk tolerance require a higher percentage of bonds and cash. CDs may be grouped under the cash asset class, but long-term CDs are more like bonds.
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So why replace bonds with CDs?
Less risk. First, CDs that are purchased directly from banks and credit unions have less risk, and that applies to both credit risk and interest rate risk. Some bonds such as U.S. Treasuries are nearly free of credit risk (the U.S. government has little chance of defaulting on its debt). However, all bonds have interest rate risk. The value of the bond will go down if interest rates rise. In the current economic environment with rates near zero, rising interest rates are very likely in the coming years.
CD investors can avoid credit risk by making sure their CDs are covered by federal deposit insurance. The FDIC insures bank deposits, and the NCUA insures credit union deposits. Both the FDIC and NCUA are independent federal agencies that operate with the backing of the full faith and credit of the U.S. government. Their insurance covers deposits of at least $250,000.
Interest rate risk can be avoided by purchasing CDs directly from banks and credit unions. These direct CDs don't lose value when interest rates rise. If a CD investor chooses to withdraw funds from a CD before the CD matures, the investor would typically be charged an early withdrawal penalty that is insensitive to interest rates.
CD early withdrawal penalties do vary based on the institution and the length of the CD term. Some banks and credit unions have mild early withdrawal penalties, and this makes the CD more attractive. It gives the investor more flexibility to redeploy the CD funds if a better opportunity arises.
Higher yield. Another advantage that CDs have over bonds is yield. For bonds that have essentially no credit risk such as U.S. Treasuries, direct CD rates can exceed the rates offered by US Treasuries with the same maturities. This has not always been the case, but in today's environment, it's easy to find banks and credit unions that have five-year CD rates almost double the yields of five-year Treasuries.
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IRA CDs. If an investor decides on adding CDs to their portfolio, holding them inside an IRA (where they're known as IRA CDs) can offer several tax benefits. Held outside of an IRA, CD interest is taxed as ordinary income. That is often a tax rate that's higher than the tax rate of dividends or capital gains from stocks. If an investor has a portfolio with portions that are held both inside and outside of an IRA, a tax savings strategy is to include bonds and CDs inside IRAs and stocks outside of an IRA.
There are two ways to open an IRA CD. One is to open an IRA CD directly from a bank or credit union. The other is to purchase a brokered CD within an IRA held at a brokerage firm. Brokered CDs can have some advantages over direct CDs, but direct CDs have two important advantages: higher interest rates and no interest rate risk.
Brokered CDs do occasionally offer higher rates than direct CDs. That's especially the case if one only looks at local brick-and-mortar banks. However, if one looks at all available credit unions, brick-and-mortar banks and internet banks, it's now much more likely that a higher IRA CD rate can be found.
Brokered CDs have interest rate risks that are similar to bonds since like bonds, brokered CDs must be sold if funds are needed before maturity. For the case of brokered CDs, the investor must sell the CD on the secondary market.
The opening process for direct IRA CDs is similar to the opening process of regular CDs. More complications exist with an IRA CD due to the limitations and requirements of an IRA. The IRS limits contributions that can be made into an IRA. If an investor is opening his first IRA, the contribution limit will keep the initial deposit into the IRA fairly small. A more common way that investors fund an IRA is by making a rollover or a trustee-to-trustee transfer. Both allow an investor to move funds from one retirement account to another without being subjected to federal income tax.
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The bottom line. For investors who value risk-free investments, replacing at least some bonds with CDs in a portfolio makes sense. Holding those CDs inside an IRA makes even more sense since IRAs will save investors money on their taxes. For investors who want to maximize their CD rates and eliminate interest rate risks, direct CDs have the advantage over brokered CDs.
Ken Tumin is the founding editor of The Bank Deals Blog at DepositAccounts.com, where he has been covering bank deals and deposit investment strategies since 2005. His insights are gleaned from DepositAccounts' patented rate-tracking technology and its community of fervent savers, along with his own decades of experience in investing in bank-offered savings products.
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