CDs, or certificates of deposit, offer a viable option for managing your finances. Whether you have surplus cash that you anticipate needing in the near future or you are planning for a significant event like a wedding or a down payment on a house, consider investing in a CD.
According to certified financial planner Jim Kinney at Financial Pathway Advisors, incorporating CDs into your overall asset allocation strategy is a wise decision. He suggests that a moderate asset allocation might consist of 60% stocks, 35% bonds, and 5% cash. Kinney emphasizes that CDs serve as an excellent vehicle for the cash portion of this allocation. Even during periods of low interest rates, many investors overlooked the importance of dedicating a portion of their diversified portfolio to cash. However, with two-year CD yields currently exceeding 5%, now is the perfect time to consider this investment option (find some of the highest paying CDs available [here]).
Despite the attractive returns offered by CDs, it is important not to allocate all your cash exclusively to this investment. Instead, carefully evaluate your financial goals and consider how CDs can be a beneficial addition to your overall financial strategy.
What Not to Use a CD For
Although there are many good reasons to buy a CD these days, there are some instances in which you should avoid them altogether.
Emergency Savings
“You should not use a CD for your emergency savings,” says certified financial planner Alvin Carlos at District Capital Management. Because CDs effectively tie up your money for anywhere from three months to five years, you don’t want to put any funds you’ll need access to in a position where you’ll be penalized for accessing them. Indeed, should you need to touch your emergency fund before a CD matures, you’ll have to pay a penalty and likely be forced to withdraw the remaining funds left in the account.
Long-Term Investments
“You also don’t want to use a CD for long-term investments, if you don’t want to leave money on the table. Stocks are the preferred vehicle for long-term investments given its higher potential for growth,” says Carlos. Adds certified financial planner Eric Ross at F2 Wealth: “I also don’t recommend CDs be used as a long-term investment strategy. They’re great for needs ranging from a few months to a few years, but anything beyond that and there are likely better options.”
Investing in Stocks and CDs: Exploring Alternative Options
When it comes to investing, the stock market has long been a go-to choice for many individuals. According to McKinsey data, historical returns have averaged around 6.5%-7% annually. However, it is important to consider the potential effects of inflation on your investments over time.
Certified financial planner John Piershale of John Piershale Wealth Management suggests a strategy that involves allocating longer-term funds to a diversified portfolio of good quality stocks, while shorter-term funds can be placed in Certificates of Deposit (CDs). This approach aims to balance potential growth with stability, taking into account your personal risk tolerance.
To make the most of CDs, it is crucial to be mindful of deposit insurance limits provided by the Federal Deposit Insurance Corporation (FDIC). The standard insurance amount is set at $250,000 per depositor, per bank, for each account ownership category. It is essential to avoid exceeding these limits to ensure your funds are fully protected.
For those who fall into the affluent category, exploring alternative options may be worth considering. Piershale highlights the importance of researching tax-free bonds as an alternative investment avenue. Unlike CD interest, which is taxed at your highest marginal income tax bracket, tax-free bonds can provide potential tax advantages for individuals in high tax brackets.
By carefully considering these factors and diversifying your investment approach, you can better navigate the world of stocks and CDs. Remember, seeking guidance from a qualified financial professional is always advisable to ensure you make informed decisions tailored to your individual financial goals and circumstances.
CD Tax Treatment for Higher Income Households
According to financial planner Matt Hylland at Arnold and Mote Wealth Management, CDs have unfavorable tax treatment for higher income households when compared to other alternatives. The interest earned from brokered CDs is taxed at ordinary federal and state income tax rates. If you are purchasing a CD in a taxable account, outside of a retirement account like an IRA, it is recommended to compare the tax liability or tax equivalent yield of a CD with other options such as Treasury bills or municipal bonds.
Tax Comparisons
Hylland specifically points out that there are current rates to consider. For instance, a one-year brokered CD may have a rate of 5.3%, while a one-year Treasury bill offers a yield of 5.23%. However, it is important to factor in the applicable tax rates when making a decision. If you reside in a state or local municipality with a higher tax rate, it may be advantageous to choose the one-year Treasury bill since it is not subject to state or federal taxes.
It is essential to assess the tax implications and explore different options before making any investment decisions. By considering the tax equivalent yield and understanding how different investments are taxed, individuals can make informed choices that align with their financial goals and circumstances.