Retirement savers are usually focused on using stocks and bonds to build a diversified portfolio. However, when investors near retirement or want to take a more conservative approach to building their nest egg, low-risk investments like individual retirement account certificates of deposit may come into play.
IRA CDs are like regular CDs, which pay interest as long as the funds remain committed to the CD. An IRA CD differs in that it has additional tax advantages.
In a traditional IRA, contributions are tax-deductible, while withdrawals are subject to taxes. In a Roth IRA, contributions are made with post-tax dollars and withdrawals are tax-free.
In either case, your CD is protected by the Federal Deposit Insurance Corporation--insured up to $250,000 in principal. Stocks and bonds, meanwhile, can lead to hefty losses. However, the safety of IRA CDs doesn't necessarily justify their presence in your retirement portfolio (at least not yet). Consider these factors:
Impact on your portfolio. Because of the low risk involved with CDs, they tend to yield lower returns compared to riskier investments, such as stocks and bonds. Such safety is exactly what many investors are looking for when they prefer more stability in their investments. However, a portfolio that consists mostly of IRA CDs is likely to grow at a slower pace, which means your retirement savings will be smaller than one with a diversified allocation in stocks and bonds.
Ideally, you'll shift retirement funds into IRA CDs when you're approaching retirement--not when you're young.
Contribution tradeoffs. Generally, there are two ways to open an IRA CD. You may be able to invest in a CD directly through your brokerage firm, which works with other financial institutions to offer CDs without having to open an account at each institution. The other option is to go to a bank.
If you take that route, your new deposit will count as an IRA contribution. Since you are limited to the amount you can contribute to IRAs per year, a new IRA CD will effectively reduce how much you can contribute to investments that have the potential for higher returns.
Early withdrawals and IRS penalties. Like most CDs, you'll get hit with an early withdrawal penalty if you make a withdrawal before an IRA CD matures (the penalties vary by bank and by CD duration).
The only exception is if you begin collecting required minimum distributions from a traditional IRA when you hit age 70.5, in which case some banks will waive the early withdrawal penalty.
After an early withdrawal, be prepared to transfer the funds to another IRA. Otherwise, if you decide to withdraw the money for good (before age 59.5), you're subject to an IRS tax penalty of 10 percent.
Simon Zhen is a columnist and staff writer for MyBankTracker.com, where he covers banking, financial technology and savings rates.