Are CDs a Good Investment for Retirement Income?

When Are CDs a Good Investment?

Certificates of Deposit
CDs are safe, but are they a good investment?. Comstock/Stockbyte/GettyImages

Are CDs (certificates of deposit) a good investment? It depends on what you want to accomplish. When you invest money, it has a job to do for you. If you need a specific amount of money available to you at a certain time in the future, and you want no investment risk, then buying a CD that matures at the point in time might the perfect investment choice.

If you are investing for something that is many years away, then although CDs are a safe investment, you need to be careful, because sometimes you can very safely lose money.

Safely Losing Money?

How can you lose money in a safe investment like CDs? Let’s look at an example.

  • Suppose you are considering a $10,000 CD that matures in five years and pays 3% a year in interest. Your CD pays $300 a year in interest.
  • Let's assume you pay taxes at a 25% federal rate and 5% state rate. This means you'll owe $90 a year in taxes on the CD interest each year.
  • Suppose inflation is 3% a year. At the end of the year, at a 3% inflation rate, it takes $309 to buy $300 of goods and services. After taxes, your CD delivered $210.

Taxes and inflation can cause you to lose money over time in things like CDs that appear to be good investments.

CDs for Retirement Income

If you take the time to design a retirement plan, you should know what minimum rate of return you need to achieve your retirement goals. If you need only a 4% rate of return to meet your retirement goals, and you can find a CD that pays 4% or more, than a CD might be the perfect investment for you.

In such a case you might be able to create a ladder of CDs that mature at a time that is appropriate to meet your future retirement income needs.

If CDs do not achieve the rate of return you need to achieve your goals than you have a few choices:

  • Work longer or find a way to reduce living expenses so that you can achieve your goals on the returns offered by CDs.

CD Rates

CD rates change. If CDs are not a good investment today, it does not mean they won’t be a good investment for you at some point in the future. When you look at historical safe investment returns you can see that in the past CDs have paid attractive rates. Today, however, rates are low and it is hard to earn much unless you lock up your funds for a long time.

When you look for CDs learn how to shop for the best CD rates. As interest rates change and as your goals change, be sure to reevaluate your investment choices.

Who Are CDs Best For?

In general, CDs are a good investment if you:

  • Are in a low tax bracket.
  • Want no investment risk.
  • Have a primary goal of preservation of capital.
  • Have a specific use in mind for the funds at a time in the future that matches the CD maturity date.
  • Can lock in a rate of return higher than inflation over the time period you need. For example, if you are in a low tax bracket, don’t need the funds for ten years, and you could buy a ten year CD paying 5%, and you expect inflation to be 3%, that would be a good investment.

If you are in a higher tax bracket, consider tax-deferred or tax-free alternative to CDs such as iBonds, fixed annuities, ultra short-term bonds or bond funds, or short-term municipal bonds or bond funds.

CDs are a bad investment if you:

  • Are losing money after you factor in taxes and inflation.
  • Have a primary investment goal of growth or income. (In a higher interest rate environment CDs might be a suitable investment for a goal of income.)

What About Equity-linked CDs or Market-linked CDs?

If you want safety, invest for safety. If you want growth, invest for growth. What an equity CD proposes is that you can have ​the safety of principal (depending on the terms of the CD) while potentially being able to participate in higher returns if the stock market does well.

I think you are better off separating out your investment goals rather than trying to accomplish multiple goals with a single investment product. For this reason, I am not a fan of equity-linked CDs. I would rather see you put some money in a regular CD and some money in an equity index mutual fund.

The FDIC also proposes you use caution and provides additional information on equity-linked CDs in the article Market-Linked CDs: Don't Let the Possibility of Higher Returns Cloud Your View of the Potential Risks.