We know that one of the most important things you can do for your long term finances is to prepare for difficulties with the help of cash. Cash offers you more liquidity that many other assets, including stocks, and it comes with the added bonus of not losing value. When you invest in stocks or bonds, you run the risk of losing some of your principal. With cash, your capital is preserved, as long as you keep your money in a financial institution that is protected with federal insurance.
The downside to using cash, though, is that it offers such low returns. In a traditional savings account, you might be likely to see a 1% APY. It’s certainly not going to help you build wealth — and you will probably lose money in terms of purchasing power.
One of the ways that many people try to get their cash to do a little more work for them is by opening a CD. While CD rates are likely to remain relatively low for a while, the right CD can still get you a better yield than what you would find from a savings account. Additionally, many people like to employ a CD laddering strategy to attempt to take advantage of rates as best they can, while maintaining some degree of liquidity.
In any case, there are good reasons to open a CD if you are looking for safety for a chunk of your money. Some people even use CDs in their emergency funds. But, before you decide to put your money in a CD, it’s important to understand some of the realities that come with CDs:
Penalties for Early Withdrawal
One of the biggest pitfalls to watch out for is the penalty that comes with early withdrawal. While there are some banks that offer CDs that won’t penalize you for early withdrawal, these are few and far between. If you do find a financial institution that won’t penalize you for early withdrawal, make sure you read the terms. Your yield is likely to be lower, or you might find other unfavorable terms, such as a call option, that can make the lack of a penalty hardly worth it.
For the most part, if you take money out before the term ends, you will be hit with a hefty penalty that can destroy some of the returns. This is a big deal, since the yield you receive on a CD is often quite low to begin with. Loss to inflation is a very real possibility if you keep a CD to its maturity; get hit with an early withdrawal penalty and real losses are virtually guaranteed.
While it is tempting to get a long-term CD because you often end up with the highest CD rates, be realistic about how long you will keep the money in the account. If you know you will need it sooner rather than later, consider getting a shorter term, even if it means a lower yield. You can also use a laddering strategy so that various CDs mature at different times, in order to still get access to a portion of your money without the early withdrawal penalties.
You Owe Taxes on Interest Paid Each Year
If your bank pays interest on your CD during the term, you are supposed to report that as income to the IRS. So, if your bank pays the interest that your CD earns annually, semi-annually, quarterly, or monthly, you are expected to report that, and pay taxes on it for the year the interest was earned and paid. When the bank sends you a check for the interest, or puts it in your checking account, this is fairly easy to do. You see that the money has arrived.
However, if the bank pays the interest by adding it to the CD account, it’s harder to keep track of. Even if you don’t actually receive the money because it goes right into the CD, the IRS still expects you to report it and pay taxes on it. The exception is if the bank doesn’t pay your interest until the end of the CD term. At that point, you pay taxes on the total interest, as you receive it. In many cases, once you reach a certain amount of interest paid out in a year, the bank will issue you a 1099-INT that spells out what you have earned.
Many people like the idea of a CD that puts the interest back in because it means better earnings overall. You end up earning interest on the yield, so that means your next interest payment is higher. However, it also means that you have to ready to pay taxes. For the most part, though, unless you have a large sum of money in CDs, your taxes aren’t likely to be that huge. Your interest earned will be added to your regular income for the year, and unless you are close to being in a new tax bracket, it might not make a big difference.
Before you put money in a CD, it’s important to look at your finances as a whole. Consider whether or not you are likely to need the money, and think about what you can expect from the money. Know the purpose, and realize that if you withdraw early, you will be penalized. Also, make sure that you include potential interest earnings from your CD in your overall tax planning for the year.