The Downside of CDs: What You Need to Watch Out For

Certificates of deposit (CDs) are currently offering some eye-popping APYs. As of Jan. 31, 2024, the best CDs on our list are paying out at rates up to 5.30%. That makes this only the third time since the turn of the century that CD rates have surpassed 5% (the first was in 2000 and the last in 2007), so now's a great opportunity to lock into a high rate before they drop again.

But for all their strengths, CDs aren't completely without risks. If you're on the fence about buying one, here are a few downsides to keep in mind.

You could lose money in a CD

Excluding no-penalty CDs, most CDs have an early withdrawal penalty. And yes -- the penalty could result in a loss.

CD penalties are usually equal to several months of interest, whether earned or not. Often the longer the term, the more severe the penalty. For example, Wells Fargo imposes a penalty equal to three month's interest for any CD terms between three and 12 months, while any CD term longer than 24 months would incur a penalty equal to 12 months' interest.

Now, let's say you get a 2-year CD from Wells Fargo and decide to withdraw early after three months. Since the penalty is equal to 12 months' interest, your three months' interest would be wiped out, plus you would pay out of pocket the equivalent of nine months' interest. Yeah, ouch.

A no-penalty CD could mitigate this risk, but banks don't offer as many no-penalty terms, plus the APYs can be weak. The exception is Raisin, which offers a slew of great no-penalty CDs with plenty of APYs above 5%.

You have to pay taxes on CD interest

I know -- taxes, ugh.

Any interest you earn from a CD will be subject to both state and federal taxes. Generally, you'll include whatever interest you earn within a year on your tax return. For instance, if you have a 5-year CD, you would report your earnings for each year of that term. The tax rate on your CD is the same as the rate on your ordinary income, between 10% and 37% for 2023 taxes.

That said, if you hold a CD within a tax-sheltered retirement account, like an IRA, you wouldn't pay taxes on interest every year. Instead, you would pay taxes at your ordinary tax rate when you withdraw money in retirement.

Most interest-bearing accounts are taxable income, such as savings accounts. If you live in a state with a high tax rate -- like California or New York -- you might be better off getting T-bills, which have comparable rates to CDs but don't impose taxes at the state level.

Decide if a CD fits your financial plan

A CD can lock in today's high interest rates, helping you earn more for longer periods. But don't be fooled by the "competitive" APYs; CDs won't make you rich. They're great if you're approaching retirement or saving for a near-term goal. But for bigger savings targets -- like retirement -- you might be better off with long-term investments, like stocks and ETFs.