Individual Retirement Accounts (IRAs) vs. Certificates of Deposit (CDs): An Overview
An individual retirement account (IRA) and a certificate of deposit (CD) are two types of savings accounts that can be obtained at financial institutions, including banks. While they are designed to help people save, they are inherently different. An IRA is designed for long-term investing for retirement income while a CD is considered a short-term savings account.
An IRA is a retirement investment account that has tax advantages to the saver and restrictions on its use before reaching retirement age. The account holder may contribute to it every year, up to limits set by the Internal Revenue Service (IRS). A CD is, essentially, a type of savings account. The account holder gets a little more interest in return for keeping the money in the account for some period of time from six months to five years.
The owners of IRA accounts can choose to invest the money in any of a large assortment of stocks, bonds, exchange-traded funds (ETFs), and mutual funds. In fact, they can choose to invest some of it in CDs.
- Individual retirement accounts and certificates of deposit provide investors with different savings opportunities.
- An IRA is a tax-advantaged retirement account that allows the account holder to keep it for decades and add to it from year to year.
- A CD is a type of savings account that gets a slightly higher interest rate than a regular savings account in return for a commitment to keep the money in for a set term.
- Both types of accounts can be opened at a bank, a brokerage, or another financial institution.
- IRAs give investors certain tax breaks, depending on the type, while CD holders must report any interest income above $10.
Individual Retirement Accounts (IRAs)
The IRA was created by the federal government to encourage Americans to save money towards their retirement years. The account holder may make annual contributions for decades as the balance grows. After age 59½, the account holder may begin withdrawing the money (and, if it's a traditional IRA, paying the taxes due on the withdrawals).
The IRS sets eligibility requirements, limits on how and when you can make contributions, as well as the amount of the required minimum distributions (RMDs) that you must start taking from your traditional IRA account. The age at which you must begin taking these distributions depends on your age:
- Take RMDs if you turn 73 on or after Jan. 1, 2023, as per the SECURE Act 2.0
- Take RMDs if you turned 72 between Jan. 1, 2020, and Dec. 31, 2022, as per the SECURE Act
- Take RMDs if you turned 70½ on or before Dec. 31, 2019
The IRS also determines the tax treatment for the various types of IRA accounts.
IRA account holders choose the investments in their accounts. The returns depend on the performance of the investments held in the IRA account. The maximum you can contribute to an IRA in 2022 is $6,000 ($7,000 if you are age 50 or older) each year or your annual taxable income, whichever is lower. The maximum contribution amount for an IRA in 2023 is $6,500 (or $7,500 if you are age 50 or older).
Traditional IRA regulations allow you to take early withdrawals (before age 59½) 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 earnings (otherwise penalties apply).
CDs are usually insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000. IRAs are not insured.
Certificates of Deposit (CD)
A certificate of deposit (CD) is a savings instrument that is issued and administered by banks, credit unions, and brokers. CDs are considered one of the safest investments available. A CD is as safe as a bank savings account, but it pays a little more interest in return for a commitment to keep the money in the bank for a set period of time.
These types of accounts are safer than stocks or even bonds but they do offer lower returns. They are insured by the FDIC if they are issued by an FDIC-insured bank.
CDs pay a specified interest rate over a defined period and repay your principal at maturity. Therefore, CD owners know going in how much they will earn over the life of a CD. They can be issued in any denomination, and their 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 will owe a penalty.
The IRS sets limits on who can contribute to a Roth IRA. In 2023, you can't contribute to one if you earn more than:
- $153,000 and file as single or head of household
- $228,000 and file married filing jointly
- $10,000 and file married filing separately
Types of IRAs and CDs
Investors have different IRA and CD options available to them when it comes time to invest. There are generally four different IRAs that investors can choose from, depending on their situation:
- Traditional IRAs allow investors to make tax-deductible contributions
- Roth IRAs give investors tax-free income
- SEP IRAs let employers (usually small businesses or self-employed individuals) make contributions to a traditional IRA for an employee
- SIMPLE IRAs offer small business employers and employees the opportunity to invest matching contributions to a retirement plan as long as they have no other retirement savings plan set up
CDs also come in many shapes and sizes. Here are some of the most common ones you can find:
- Standard or traditional CDs come with fixed/locked-in interest rates, minimum deposit requirements, and fixed terms. Early withdrawals come with a penalty
- High-yield CDs provide better rates than standard or traditional CDs
- Bump-up CDs allow investors to get better rates (usually once per CD term) if their institution raises interest rates
- No-penalty CDs come with lower interest rates but give investors the option of withdrawing their money early
Another key difference between IRAs and CDs is how they are treated for tax purposes. IRAs provide certain tax breaks to investors, depending on the vehicle they choose.
Contributions made to a traditional IRA are tax-deductible, as long as you meet the income and tax-filing status requirements. This means that you contribute pretax income that grows tax-free. You only start paying taxes once you start making withdrawals. Roth IRAs work in the opposite way—you pay taxes on the contributions but earn tax-free income upon retirement.
CDs, on the other hand, come with no tax breaks. But you may owe taxes on any interest income you earn. Your institution will send you a Form 1099-INT for any interest you earn on your investment. The IRS requires that you report any interest income that exceeds $10. Keep in mind that you aren't required to pay taxes on your principal balance.
Last, each financial vehicle has its own set of goals and objectives. Each type of financial instrument is intended for a specific purpose and therefore is dictated by its own constraints.
Certificates of deposit can often not be withdrawn once the account has been created. Savers usually have to wait until the term of the CD is finished before they have access to their capital. Alternatively, some CD products allow for early withdrawal in exchange for pre-withdrawal penalties (i.e. three to six months of CD interest).
While CDs have short-term liquidity constraints, IRAs have a much different setup. Contributors to an IRA are allowed to withdraw Roth IRA contributions at any time. However, they can not withdraw any earnings from a Roth IRA until they are 59½ years old. Traditional IRA contributions and earnings can not be withdrawn until the saver is 59½. If non-eligible withdrawals are made, the saver faces taxes on the withdrawn capital in addition to a 10% IRS penalty.
Is an IRA Better Than a CD?
An IRA is a better financial vehicle for saving for retirement. It allows savers to either take a tax deduction upfront for contributions into a traditional IRA. Alternatively, it allows savers to have their earnings grow tax-free when using a Roth IRA. If not saving for retirement, a CD may be a better option.
Does an IRA Make More Money Than a CD?
Broadly speaking, an IRA will usually make more money than a CD. This is because there are a wide assortment of investment options to choose from within an IRA. Be mindful that while there is greater growth potential in an IRA, there is also greater risks and the potential risk of loss of original capital.
Should I Move My IRA to a CD?
If you're nearing retirement, making withdrawals from your IRA, are being considerate about tax implications of withdrawals, and want financial stability, you should consider moving your IRA to a CD. Transferring capital to a CD moves it into an FDIC-insured account up to capital limits. In addition, CDs with fix rates allow savers to know exactly how much money they will have in the future (as opposed to the variability of an IRA).
The Bottom Line
An IRA and a CD are two very different financial products. An IRA is primarily used for retirement, granting the saver tax benefits for contributing into an account meant to be held long-term. A CD, on the other hand, is a short-term vehicle that locks up money for a short period. While both are great for saving money, be careful contributing to either as each have withdrawal restrictions and penalties when misused.