You can use CDs to save for retirement, but is it worth it?

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There are many ways to save for retirement. Ideally, you’ll want a relatively safe place to put your wealth and grow it over time.

Thanks to today’s high interest rates, certificates of deposit are becoming an attractive option to grow your nest egg.

CDs can definitely have a place in your retirement portfolio. They may be a good fit if you’re a few years away from retirement, or if you prioritize stability and want to avoid the volatility of other investments. But they may not make sense for everyone.

“With interest rates rising, the forgone returns from riskier assets aren't as stark as they used to be, and so we are finding many more investors, including CDs within their portfolios,” says Elliot J. Pepper, certified financial planner at Northbrook Financial.

Here’s a rundown on how CDs work and if they’re a good way to save for retirement.

Benefits of using CDs to save for retirement

CDs have much in common with regular savings accounts — but often have higher interest rates. But in exchange, you agree to lock up your cash for a set period, between 6 months and 10 years. You'll have to pay a fee if you withdraw before the term ends.

Because of this, CDs provide a stable income stream and can help preserve your capital. This can be helpful for retirement planning, as it allows you to plan and budget accordingly. Benefits of using a CD to save for retirement include:

• Guaranteed return: Because CDs have fixed interest rates, you can calculate exactly how much you'll have when the CD matures. For example, if you deposit $10,000 in a 1-year CD with a 5% APY, you’ll have $10,500 at maturity. This is different from high-yield savings accounts, which have variable rates.
• FDIC insurance: Unlike stocks, CDs are covered by FDIC insurance. This means your money is safe up to $250,000 per person, per account. This protects you if your bank fails.
• Diversification: CDs can be a valuable part of a diversified retirement portfolio. Combining CDs with other investments like stocks, bonds, or mutual funds, you can balance your risk and potentially boost your overall returns. Diversification spreads out your investments across different asset classes, reducing the impact of any single investment on your portfolio's performance.
• Flexibility: CDs come in various terms, ranging from a few months to several years. This allows you to choose a CD that aligns with your retirement timeline and financial goals. You can also open multiple CDs with different maturity dates, giving you more flexibility in accessing your funds. This called a CD ladder.

Drawbacks of using CDs to save for retirement

The low-risk, stable nature of CDs can make it attractive to grow your nest egg. However, they do come with some serious downsides including:

• Lower long-term returns: CDs often have lower returns than other investments like stocks or mutual funds. CD interest rates may not generate enough growth to meet long-term goals, especially if you’re decades away from retirement. “While a younger investor might consider CDs in their portfolio, they should not represent the majority of the portfolio since higher, albeit more volatile, returns exist in stocks,” says Pepper.
• Inflation risk: Over time, inflation erodes the purchasing power of your savings. If your CD's interest rate doesn't outpace inflation, your retirement savings may not be able to support the retirement income you want.
• Limited liquidity: When you invest in a CD, your money is locked in for a specific term until maturity. You’ll often get slapped with a fee for withdrawing your money early. This can be a drawback if you need access to your savings in case of emergencies or unexpected expenses.
• Tax implications: Interest earned on CDs is generally subject to income tax. This may reduce your overall after-tax returns. In most cases, income tax is higher than capital gains tax, which applies to assets like stocks and bonds.

Alternatives to CDs

Besides CDs, there are many other short- and long-term investments to consider for your retirement savings. This includes stocks, bonds, mutual funds, exchange-traded funds, target-date funds, and annuities.

Where you should invest depends on your retirement goals, time horizon, and risk tolerance.

It’s also important to note that successful investing is about diversification. It’s wise to put your eggs – meaning your money – in several different baskets. This means a mix of low-risk options, like CDs, money market funds, government bonds, and higher-risk places like stocks.

How to save for retirement using CDs

If you’re considering CDs for your retirement savings plan, consider these key factors.

• What’s the interest rate? This is the most important piece of the puzzle, and it’s simple: The higher the rate, the better the return. The best CD rates tend to be found at online banks, but some local credit unions also offer competitive earning potential.
• How long is the term? CDs come in a range of terms. Typically, the longer the term, the higher the interest rate you’ll get. Consider your expected retirement date and how long you want to lock up the cash.
• What’s the early withdrawal policy? Different banks have different early withdrawal penalties. They also may have their own policy on how much money you can take out if you need it earlier than expected.

What kind of CDs can I invest in?

While traditional CDs are the most common option, other CDs may make sense for your retirement plan, including

• No-penalty CDs allow you to withdraw your funds before the term ends without penalty. These CDs offer more flexibility but generally come with lower rates compared to traditional CDs.
• Bump-up CDs offer the opportunity to increase the interest rate on your CD once during its term. If interest rates rise, you can "bump up" your rate to the new, higher rate offered by the bank. This feature allows you to take advantage of favorable rate changes.
• Jumbo CDs require a larger minimum deposit compared to regular CDs. Because of this, they often offer higher interest rates.
• Step-up CDs come with built-in interest rate increases at certain intervals. The interest rate rises over the CD’s term, allowing you to earn more than a traditional CD.
• Add-on CDs are similar to savings accounts because you can make regular deposits. With traditional CDs, you have to have the total amount of cash when you open the account.

What are IRA CDs?

IRA stands for Individual Retirement Account, and IRA CDs are invested in – you guessed it – CDs. IRA CDs allow you to save for retirement while enjoying the security and fixed returns of a CD.

One of the benefits of IRA CDs is that the interest you earn on them grows on a tax-deferred basis, says Pepper. This means you won't have to pay taxes on the interest earned until you withdraw from the IRA. This can help your savings grow faster over time.

Contributions are tax-deductible and can reduce your taxable income and tax bill. However, withdrawals from traditional IRAs are generally subject to income tax.

Using a CD ladder to save for retirement

If you’re thinking about using CDs as part of your retirement portfolio, you may want to consider a CD ladder.

Instead of investing all your money into a single CD, you can divide it among CDs with varying terms. As each CD matures, you reinvest the funds into a new CD.

With a CD ladder, you have more liquidity and can benefit from rising interest rates.

“Utilizing a CD ladder strategy is a very popular method to invest in CDs but better hedge against the inflation risk,” Pepper says.

Interest rates on CDs can vary over time. A CD ladder can still provide steady income and preserve your savings when interest rates are low. But when interest rates are rising, you may miss out on higher returns if you’ve locked into longer-term CDs at lower rates.

Bottom line

CDs can feel like a solid place to store your nest egg due to their stability and steady returns. If you’re a few years away from retirement, that kind of peace of mind can be a great reason to put a chunk of your retirement savings in CDs.

But if you’re in the early days of saving for your golden years, you can earn a lot more green by accepting greater risk. CDs may not provide the same level of long-term growth compared to other investments, and returns might not keep pace with inflation.

Assessing your risk tolerance, time horizon, and retirement goals will help you decide if CDs are the right choice.

Editorial disclaimer: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.