What's the difference between an individual retirement account (IRA) and a certificate of deposit (CD)?
An Individual Retirement Account (IRA) is a tax deferred account available for anyone of any age as long as you have earned income. Once you open your account, you may invest the funds in your IRA in, but not limited to stocks, bonds, mutual funds, and/or even CDs. An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. A traditional IRA is tax deferred which you make contributions with money you may be able to deduct on your tax return, and any earnings can potentially grow tax-deferred until you withdraw them in retirement.
A Certificate of Deposit (CD) is a type of fixed interest rate deposit over a specified period of time. When that term ends, you can withdraw your money or roll it into another CD. Withdrawing before maturity can result in a penalty. It is low risk and low return. CDs are among the safest investment a person can make. The interest rate is determined ahead of time, and you’re guaranteed to get back what you put in, plus interest once the CD matures. What’s more, if the bank fails or goes under, your deposit is most probably insured by the FDIC for up to $250,000.
The difference being that an IRA is a type of account in which you may leave in cash or invest in differing securities or CDs. Whereas a CD is a time deposit at a financial institution which may be bought in either a qualified (IRA) account or a non qualified (cash) account.
An IRA account is an account type, similar to opening a brokerage account. Monies deposited into an IRA account are tax sheltered while the account grows. There are penalities for withdrawing money from an IRA account before reaching retirement age (or 59 1/2 years old currently according to the IRS).
A Certificate of Deposit is not an account type, is it technically an investment instrument, generally issued by a bank, that pays a guaranteed interest for a set period of time. The funds deposited into a CD are restricted from being withdrawn until the maturity date. Early withdrawl will result in a stiff penalty.
It is possible to own a CD inside an IRA account. While that's generally not done because it is a very conservative approach, it is possible for those who are very risk averse to buy CD's in their IRA accounts.
An IRA (Individual Retirement Account) can be thought of as an individual savings account that has tax benefits. You open an IRA for yourself (that's why it's called an individual retirement account) and if you have a spouse, you'll each have a separate account. An important distinction to make is that an IRA is not an investment itself; rather, it is an account where you keep investments such as stocks, bonds and mutual funds. You get to choose the investments in the account, and can change the investments if you wish. Your return depends on the performance of the investments held in the IRA account. An IRA continues to accumulate contributions and interest until you reach retirement age, meaning you could have an IRA for decades before making any withdrawals.
IRAs are defined and regulated by the IRS, which sets eligibility requirements, limits on how and when you can make contributions, takes distributions, and determines the tax treatment for the various types of IRA accounts.
For example, as of 2016, the maximum you can contribute each year to your traditional or Roth IRA is $5,500 ($6,500 if you're age 50 or older) or your taxable income for the year, whichever is lower. Traditional IRA regulations allow you to take early withdrawals under certain circumstances, Roth IRA regulations are more flexible allowing you to withdraw contributions at any time, as long as you do not withdraw any of the interests earned (otherwise penalties apply).
Certificates of Deposit, on the other hand, are savings instruments issued and administered by banks, credit unions and brokers. Unlike IRAs, a CD can be jointly owned; for example, you and your spouse or you and your child could own a CD together. CDs pay a specified rate of interest over a defined period of time, and repay your principal at maturity, so you know ahead of time how much you will earn over the life of a CD. CDs can be issued in any denomination, and maturities typically range from one month to five years or longer; however, if you make a withdrawal from a CD before its maturity date, you'll owe a penalty. They are FDIC-insured if they are issued by an FDIC-insured bank.
An IRA is a tax-deferred account designed for retirement. A CD is an investment typically available at a bank. Investments in an IRA can have a penalty for early withdrawals and later has required minimum distributions, but a CD usually has a very low rate of return. Another option to consider is a Roth IRA (tax-free growth and qualified withdrawals with no required minimum distributions) for retirement and an individual account for shorter term goals. With an individual, IRA, or Roth IRA account, you can invest in low-cost ETF funds based on your goals and time horizon for historically better returns than a CD with diversified risk.
An Individual Retirement Account or IRA is a type of tax deferred retirement account. It is a receptacle for holding assets from stocks, bonds, mutual funds, and even a CD if you wanted. A Certificate of Deposit or CD is a "time deposit" by a bank or credit unions and normally has FDIC insurance. So, one is a type of account and the other is a type of investment with various maturity dates depending on which you chose. They are generally 6 month, 1 year, 2 year, and up to 5 years, but can go longer. It is not what I would recommend in this low interest rate environment unless you are putting a small portion of your portfolio into CDs as your "safe money."
Hope this helps, Dan Stewart CFA®