Which is better: IRA or CD, and how do they differ?
The decision between a CD and an IRA depends on your financial objectives. CDs provide stability for short-term goals with fixed interest rates, while IRAs allow you to invest in the stock market for long-term retirement savings. Understand how to use both types of accounts to achieve your financial goals.
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What is a CD?
A CD is a bank or credit union account that pays interest on deposited funds, with the condition that the money must be kept locked away for a specified period. Unlike savings accounts, the interest rate on a CD does not change during the term, regardless of market fluctuations. Therefore, it can be advantageous to invest in a CD when interest rates are high and are expected to decrease soon.
Our top pick for CD rates, Alliant Credit Union, provides CDs with rates of up to 5.20% APY and terms ranging from three months to 60 months, with a minimum deposit of $1,000 required.
Besides conventional CDs, there are other options such as the bump-up CD, which enables you to request a higher APY if rates rise during the term, or the no-penalty CD, which allows you to withdraw your money before the end of the term without incurring a penalty. Ally Bank provides several of these types of CDs at competitive rates and with terms ranging from three months to five years. For instance, the five-year Ally Bank High Yield CD offers a 3.90% APY with no minimum deposit required.
Alliant also provides jumbo CDs that offer higher rates for deposits of $75,000 or more.
Pros and cons of CDs
CDs can assist in saving money for a specific duration, but it is crucial to be aware of their limitations.
Pros
- Investing in CDs means you commit to keeping your money in the account for a specified period at a predetermined interest rate, which guarantees a steady return on your investment.
- CDs usually provide a higher yield than savings accounts, including some high-yield savings accounts, because you have limited flexibility in withdrawing your funds.
Cons
- You won't be able to withdraw your CD's funds before the end of the term without incurring a penalty.
- CD withdrawal penalty fees can differ among banks and depend on the CD's term length. Typically, these fees are calculated based on the interest earned or the interest that would have been earned over a specific period.
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What is an IRA?
An IRA is a tax-advantaged investment account that individuals with taxable income can set up through a financial institution. Similar to 401(k) plans, IRAs allow you to invest money into various assets such as stocks, bonds, or mutual funds. However, unlike most 401(k)s, IRAs can be opened by an individual rather than an employer.
Contributions to traditional IRAs are made with pre-tax dollars, which means you won't owe taxes on your contributions until you withdraw the money in retirement. With Roth IRAs, you contribute after-tax dollars, enabling you to make tax-free withdrawals in the future.
IRAs have annual contribution limits and a waiting period of 59 ½ before withdrawals can be made without penalty, as per the IRS. Additionally, to contribute to a Roth IRA, you must meet certain income qualifications, and if you earn too much money, you may not be eligible to fund one.
To open an IRA, consider using a reputable broker that offers commission-free trading on various securities and low-expense ratio index funds. Both Fidelity Investments and Vanguard are good options that also provide robo-advisor services for beginner investors.
Pros and cons of IRAs
To maximize your retirement savings, IRAs are a helpful tool. However, it's crucial to avoid early withdrawals as they often incur significant financial penalties.
Pros
- Traditional IRAs defer taxes on contributions until withdrawals, while Roth IRAs allow tax-free withdrawals of after-tax contributions.
- Your IRAs may provide various investment options, such as commission-free stocks or exchange-traded funds, depending on your financial institution.
Cons
- The IRS adjusts annual contribution limits for IRAs every year.
- The type of IRA determines the early withdrawal penalty. For instance, traditional IRAs typically impose a 10% penalty for early withdrawals before age 59½.
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Which is better: A CD or an IRA?
If you're saving for retirement, an IRA is usually the better option than a CD because it offers tax benefits and the potential for a higher return. However, even the safest investments carry a risk of loss, and an FDIC-insured CD is best for short-to-medium-term goals like saving for a down payment on a home.
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