Saving for Retirement? 3 Reasons CDs Are a Terrible Choice

Many people are excited about CD rates today. And that totally makes sense. 

For many years, CD rates were so low it was barely worth giving up the flexibility of a savings account. These days, you can easily lock in a 5% return with a CD, and that's basically risk-free money provided you bank somewhere that's FDIC-insured and limit your deposit to $250,000 ($500,000 for joint accounts). 

But while CDs are a great place to house your money for a limited period, they're a poor choice for retirement savings. If you're thinking of opening a CD as a means of saving for retirement, here's why you should reconsider. 

1. CD rates might fall over time

The CD rates savers are enjoying today aren't the norm. And once the Federal Reserve begins to cut rates, which could happen later this year, CD rates are apt to fall. 

Now, it's one thing to invest your retirement savings in CDs at a 5% return. But in time, CD rates could fall to the point where they don't even keep up with inflation. That's a big problem for your retirement savings, because you need your money to grow faster than inflation. If that doesn't happen, you risk not having enough money to live on down the line.

2. Even when CD rates are high, they pale in comparison to stock market returns

Although today's CD rates are outstanding, the stock market has a long history of outpacing CD rates. Over the past 50 years, the stock market's average annual return has been 10%, and that accounts for both good years and bad.

Here's what might happen if you stick to CDs over a long period. Even if you're able to score a 5% return on your CDs over the next 30 years, if you have $10,000 to set aside for retirement now, you're going to end up with about $43,200.

On the other hand, let's say you invest your $10,000 in an IRA or brokerage account and score a 10% return over the next 30 years. In that case, you're looking at growing your money into about $174,500.

Even if we go a bit more conservative and assume you'll get an 8% return in your investment portfolio over time, in 30 years, $10,000 could be worth about $100,600 if it's in the stock market. You're just not going to get close to that with CDs.

3. CDs create an immediate tax burden

The nice thing about saving for retirement in an IRA or 401(k) plan is that your money goes in tax-free (in the case of a traditional account) and grows tax-deferred over time. If your IRA or 401(k) gains value from one year to the next, you're not automatically paying the IRS a portion of those gains. Rather, you can reinvest your gains to grow your money even more. You'll pay the IRS its share at the time you take retirement plan withdrawals. 

With a CD, the interest you earn is subject to taxes the year you earn it (unless the CD is in a retirement account). You can't defer that tax obligation. If you open a CD today for retirement and earn $300 by the end of the year, you'll owe a portion of that to the IRS, depending on your tax bracket and total income picture. 

Even if you don't save for retirement in an IRA or 401(k), but rather, a regular brokerage account, if you hold stocks in that account for at least a year and a day before selling shares at a profit, you'll be looking at paying long-term capital gains taxes. The tax rate on long-term capital gains is generally much lower than the rate you'll pay on interest income in a CD.

All told, CDs are a good choice when you want to earn some interest on your money on a short-term basis. But for these reasons, they're really not a good option for building a retirement nest egg.