An individual retirement account lets you put money in each year without paying tax on it, similar to workplace accounts like 401(k)s. When you take the money out after retirement age, you then pay income tax on it. A certificate of deposit is a type of bank account with a fixed amount of time you must keep money in it or pay a penalty. You can open a CD inside or outside of an IRA through many institutions.
TL;DR (Too Long; Didn't Read)
CDs work similarly inside IRAs and as standalone accounts. If you withdraw money from a CD in an IRA to spend immediately before retirement, you'll often face a double penalty, paying the bank for early withdrawal from the CD and the IRS for the early IRA distribution.
How IRAs Work
You can open an IRA at many banks, credit unions, brokerages and other financial institutions. Each year you're allowed to contribute a certain amount of money, up to $5,500 if you're under 50-years-old and $6,500 starting once you turn 50. You can deduct that contribution from your taxes that year.
Once the money is in your account, you usually have a range of opportunities to invest it. These can include stocks and bonds, mutual funds and index funds linked to particular market indexes and sometimes bank products like certificates of deposit. Different managers might offer different products and different fee structures, so it's worth shopping around when you open an IRA.
Once you reach the retirement age of 59 1/2, you can begin withdrawing money from your IRA with no penalty. You pay taxes on the money you withdraw as ordinary income. You may want to schedule your withdrawals to minimize your taxes if you can afford to do so since a large IRA withdrawal can put you into a higher tax bracket.
If you withdraw money before retirement age, you will generally owe taxes plus an additional 10-percent penalty unless certain exceptions apply.
How CDs Work
A certificate of deposit is a special type of bank account. They typically pay more interest than other bank accounts but require you to commit to keeping your funds in the account for a certain amount of time.
Some variations on CDs exist that might let you withdraw money early without penalty or add more money to the account. Some allow you to increase the interest rate over the life of the account. Banks or credit unions issue CDs and they're generally insured by the Federal Deposit Insurance Corporation or the National Credit Union Administration up to $250,000. Interest is taxable as ordinary income.
You can sometimes purchase a CD through a stockbroker. Brokered CDs are ultimately held at banks, so they're still insured by the FDIC. They may assist you in automatically shifting deposits among multiple banks to avoid the FDIC insurance limit.
CD vs. IRA
While CDs can pay better interest rates than other bank accounts, they typically don't pay as well as investing in other things like stocks or real estate. Of course, those investments are almost never insured against loss so they can lose money, as well.
A CD is typically seen as an excellent way to store money for a short-to-medium length of time. An IRA, on the other hand, is explicitly designed for long-term savings until retirement. You'd likely use them for different goals.
Still, you can sometimes purchase a CD within an IRA account. This doesn't work differently from buying it with other funds, except that you must either contribute to the IRA or use funds already in the account to buy the CD. The difference between a CD and an IRA CD is that one is in an IRA, often alongside other investments, and one is not. Of course, if you remove funds from the CD and the IRA, you'll face a double penalty.
Buying CDs within an IRA may make sense as you near retirement age and want the account to be less volatile as you know you'll need to retire off the money in the account relatively soon. You'll still get the tax break if you buy an IRA certificate of deposit by moving money into the IRA rather than buying a CD outside of your IRA.
Money Market Accounts and Funds
Another type of investment you may consider as a CD alternative is a money market account or fund.
A money market account is a bank account that invests in short-term corporate and government debt. It is usually similar to a savings account in that you can make a maximum number of transactions per month and may be required to keep a minimum balance or incentivized to do so with a higher interest rate. Some have checking account features like checkbooks and debit cards. Money market accounts are typically FDIC insured like other bank accounts.
Money market funds are similar products available through brokerages. They're usually not FDIC insured, though they're traditionally considered fairly safe investments. They're often used to stash cash between other investments temporarily. You may open one within your IRA if you'd like to keep your funds relatively safe and liquid within the IRA. Naturally, you'd still face a penalty for early withdrawals from your IRA if you remove the funds altogether.
Understanding Roth IRAs
A Roth IRA is a special kind of IRA where you pay taxes as normal on money you put in the account. When you withdraw funds, however, you don't owe any additional tax, even on investment earnings within the Roth IRA.
You can withdraw your contributions from a Roth IRA at any time without a penalty since you've already paid tax on them. If you withdraw earnings before retirement age, you'll usually owe a penalty and income tax.
These are good accounts to use if you believe you'll be in a high tax bracket at retirement age or if you anticipate hefty returns on your investment. If you're making relatively low-risk and low-return investments like CDs or money market funds in your IRA, a Roth account may not bring you the same advantage since saving taxes on that interest won't help as much.
Your annual contribution limits apply to all of your traditional IRAs and Roth IRAs together, so you can't contribute more to your retirement by opening more IRAs or more types of IRA.
Required Minimum Distributions
Once you turn 70 1/2, you must begin to withdraw money from your IRA accounts under IRS rules. There is a required minimum distribution you must take each year to avoid a tax penalty.
IRS tables specify your minimum distribution each year based on your age and account balance. If you don't take the distributions that are required for your age, you can be subject to large tax penalties. These can be up to 50 percent of the amount improperly left in your account, which under current tax brackets is always going to be larger than the federal income tax you'd incur by taking money out of the account.
If you have money in an IRA CD, this can be an issue since you might be required to take money out of your account that is tied up in a CD. Some banks and institutions will waive their fees if this situation applies. Contact your institution if you think this issue may apply to you.
- Bankrate: The Pros and Cons of IRA CDs
- Investopedia: Money Market Account
- FDIC: Deposit Insurance FAQs
- Nerdwallet: How to Avoid a CD Early Withdrawal Penalty
- IRS: Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-A (2017), Contributions to Individual Retirement Arrangements (IRAs)
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.