​​Can CDs Help You Save For Retirement?

Certificates of deposit (CDs) are all the rage right now. With annual percentage yields (APYs) as high as 5% on some accounts, it isn't hard to see why. When you buy a CD, you commit to leaving your money alone for a set period. In exchange, you'll earn a fixed rate of return that's often higher than you'll get with a savings account.

If you're planning for your old age, those guaranteed returns may seem like a good option. Particularly as CDs are almost always FDIC-insured. However, CDs usually work best as short- or medium-term savings vehicles, rather than investments. As such, depending on how close you are to retirement, CDs may not help you reach your goals.

If you're considering including CDs in your retirement planning, here are two factors to consider.

1. Investing is riskier, but it could generate higher returns

Knowing the difference between saving and investing is crucial when it comes to building up a retirement fund.

• Saving is a lower-risk way to put money aside for the near term. That might mean your emergency fund, a deposit on a house, or your vacation money.
• Investing is about buying assets you think will accumulate value over time. That might mean buying stocks, bonds, property, or other assets. It's riskier than saving but has the potential to grow your money more. For example, in the past 30 years, the S&P 500 has generated average annual returns of just under 10%.

Put simply, if you're trying to build money for your twilight years, savings accounts and CDs will only get you part of the way. Not only do you need to beat inflation, you'll also need to build up enough money to cover your living costs for several decades. That means taking some risks in order to earn higher annual returns.

Even if top CD rates stay at 5% for the coming couple of decades -- which is extremely unlikely -- they still won't beat any potential investment gains. If we assume your investments might earn 8% a year, that can make a big difference over time.

Let's say you start with $10,000 in your retirement account and contribute $500 each month. Here's a simple illustration of how much you might accumulate, without factoring in inflation.

Actionable takeaway:

The risk-to-reward ratio changes as you get closer to retirement. If you have 30 or 40 years to build wealth, it makes sense to take on more risk for higher returns. You'll have time to handle short-term market fluctuations or recover if an investment doesn't pan out.

But if you are nearing retirement, you'll likely want to decrease your risk exposure. In that scenario, the current high CD rates may make them worth including in your portfolio. Even then, bear in mind that CDs are not your only option. Investigate the risks and rewards of other low-risk investments, such as Treasury bills or bonds.

2. You may have to pay tax on your CD returns

It is not easy to build up a nest egg for your old age. One way the government helps is by offering tax breaks on the money you invest for retirement. If you buy stocks through a work 401(k) or an individual retirement account (IRA), you either reduce your taxable income now or make tax-free withdrawals later on. This can be a significant boost for your nest egg.

Many CD accounts are taxable, so you'll need to declare and pay income taxes on any gains. However, it's possible to get the tax benefits of an IRA alongside the guaranteed returns of a CD. Some brokerage IRAs allow CDs, or you could open an IRA CD with a bank.

Actionable takeaway:

If you want to make CD investing part of your retirement portfolio, learn more about IRA CDs. Be aware that there are annual limits on the total amount you can contribute to your IRAs, whatever assets you buy.

Plus, you need to be sure you won't need to access that cash early. There's usually an early withdrawal penalty if you take out the money before the end of the CD term. Worse? If you withdraw cash from the IRA before you reach age 59 1/2, there's also a 10% tax penalty.

Bottom line

There's no single magic formula for saving for retirement. The trick is to build a diverse portfolio of assets that works for your situation in life. As such, in some scenarios, it may make sense to include CDs in your portfolio -- particularly if you can do so in a tax-advantaged way. Just be aware that CDs rates will almost certainly fall at some point. And in the long run, you may well get higher returns by investing in the stock market.