6 Do’s and Don’ts When Using CDs for Retirement

Certificates of deposit work as a short-term savings vehicle for goals such as upcoming home or car purchases. If you’re near or in retirement, you might wonder if CDs fit there too.

For risk-averse folks, CDs can be appealing. Safety is central to them: CDs offer predictable returns, federal deposit insurance and no volatility in value such as in the stock market.

“CDs are like that big, comfortable hug in the investing world,” says Noah Damsky, chartered financial analyst and founder of Marina Wealth Advisors in Los Angeles.

But CDs aren’t the most flexible among low-risk savings options. Here are some quick tips for what to do and not do when using CDs for retirement.

Whether you’re near retirement or not, an emergency fund is a primary goal for short-term savings. Having three to six months’ worth of living expenses, or more, in a regular savings account tends to be a common recommendation.

CDs aren’t best for emergency cash because they require locking up a fixed sum for a period, typically ranging from three months to five years. But preserving extra cash reserves, beyond savings for emergencies, in CDs can make sense, especially since their yields are traditionally higher than in other bank accounts.

“CDs play an important role as an emergency fund supplement in retirement,” says Daniel Masuda Lehrman, certified financial planner and founder of Masuda Lehrman Wealth in Honolulu.

Having a CD’s fixed rate during a high-rate environment can mean steady, solid returns for years. But in exchange, you lose access to funds for the term.

One workaround to preserve some access is a CD ladder. Instead of one CD, you divide an investment into equal amounts and put them into CDs of staggered term lengths, such as one year, two years and three years. Shorter terms work, too: three months, six months and nine months. The idea is that you can access some cash each time a CD matures, while letting the rest of an investment grow.

Your bank’s CDs might be convenient but not always the best deal. Online banks and credit unions tend to have some of the best CD rates, and their opening minimum deposits are often low, such as $1,000 or less. Current high-yield rates remain near or above 5% annual percentage yield for six-month and one-year terms, while longer-term rates such as for three and five years are closer to 4%, according to NerdWallet analysis in April.

You can also find competitive yields with brokered CDs, which are issued by banks and available at a brokerage. You need a brokerage account and some understanding of how these CDs work, though.

“A brokered CD is going to be most valuable to somebody who has a substantial amount of assets,” says David John, senior strategic policy advisor at the AARP Public Policy Institute. John cites a brokerage’s ability to spread funds across multiple financial institutions to ensure customers don’t hit the $250,000 cap for federal deposit insurance, which protects your money if a bank fails.

You generally can’t redeem CDs early without hassle or cost. At banks, CDs’ early withdrawals often come with a penalty, such as months to years’ worth of interest earned. A bank may let you withdraw interest early from a CD, but you’d lose out on the full amount a CD can earn from compounding interest.

At brokerages, you can leave a CD early by selling, but you risk losing some of the original value if current rates are higher than your CD’s rate.

Once a CD ends, there’s a grace period, typically seven to 10 days long, when you can withdraw the full amount without a penalty. Alternatively, you can consider a no-penalty CD, though rates tend to be lower than high-yield CDs at the same bank.

For most of the last decade or so, CD rates were at rock-bottom lows and the tax burden for CD interest was minimal. But that’s changed with higher rates in recent years.

“Sometimes folks forget that you can have a meaningful tax impact having this money in a CD,” Damsky says.

CD interest gets taxed at the same rate as regular income for the year you earned that interest. Having $10,000 in a one-year CD at 5% APY, for example, means you’re taxed on that $500 in interest. However, you can reduce your tax burden with IRA CDs, which are tax-advantaged accounts invested in CDs.

One of the biggest mistakes Damsky sees for retirees is getting too averse to risk when investing, especially by overusing CDs. Sometimes the pitfalls with CDs, such as the lack of flexibility and access to funds compared with other low-risk alternatives, can outweigh the pros, he says.

Low-risk investment alternatives to CDs, such as money market funds, can have comparable returns with easier access to cash for brokerage customers. And within an investment portfolio, stocks and bonds play bigger roles than cash investments such as CDs do over time. Stocks historically have provided the greatest likelihood for strong returns while bonds balance out stocks’ volatility with more stability. As John points out, CDs often can’t completely protect against inflation the way other investments can.