What Is an Indexed Certificate of Deposit?
An indexed certificate of deposit (CD) is a savings account with a rate of return that fluctuates with the movements of a specific stock market index, such as the Standard & Poor's 500 Index. As with any certificate of deposit, the money is deposited for an agreed-upon period of time.
An indexed CD appeals to savers who would like to ensure that their savings keep up with the return on stocks while avoiding risk to principal. Certificates of deposit are sometimes called market-linked or equity-linked certificates of deposit. An equity-linked certificate of deposit may be tied to a basket of stocks rather than a stock market index.
The Basics of Indexed CDs
Certificates of deposit, in general, are considered virtually risk-free, as the principal invested is guaranteed by the Federal Deposit Insurance Corporation (FDIC). However, the returns on an indexed CD are not guaranteed. Many investors look at these products as a safer way to invest in the stock market or a slightly riskier money market product.
- Indexed CDs have a rate of return that shifts with the movement of a specific stock market index.
- This allows an investor to ensure their investment keeps pace with stock market returns without added risk.
- Indexed CDs may have a minimum guaranteed return, but they can have a cap on the return as well.
How Returns Are Calculated for CDs
Indexed CDs are offered by banks and other financial institutions, and the precise terms vary. Some match 100% of the return generated by the index upon which it is based, while others specify a lesser percentage, often 90%. This is referred to as the "participation rate" of the CD.
Some offer a guaranteed minimum return even if the associated index takes an unexpected dive. It is important to note that some issuers cap the CD's return, too, effectively limiting the investor's potential gain (and the issuing institution's loss).
The issuer also has the right to "call," or "redeem," an indexed CD before its date of maturity. The "call price," or the amount that the bank agrees to pay in interest, will be set out in advance in the fine print. In any case, the investor is guaranteed to get the original investment at the end of the CD's term. The FDIC guarantees the deposit up to $250,000.
Indexed CD interest is taxed as interest income and not capital gains.
Pros and Cons of CDs
In addition to a high degree of safety, an indexed CD offers some opportunity for growth beyond the minimal amounts available in ordinary savings accounts.
However, as in any CD, investing in an indexed CD involves tying up money for an extended period of time. A three-year or five-year term is common for these types of deposits, with penalties attached for early withdrawal. That is notably different from other CDs, which are available in much shorter term lengths.
Some issuers offer a brief annual window during which principal may be withdrawn without penalty. However, they are an investment choice best suited to a person who does not expect to need access to that money in the near future.
Unlike traditional CDs that are available in short durations, such as 21 days or six months, indexed CDs typically have a three- or five-year duration.
Tax Implications of Indexed CDs
The interest on an indexed CD is due for the year in which it was earned, assuming that the money is not held in a retirement account such as a 401(k).