Should You Include CDs in Your Retirement Portfolio?


2 December,2013

When putting together a retirement portfolio, it’s a good idea to include different types of assets for diversity and to reduce the risk associated with your portfolio. One of the worst things you can do for your financial future is to put all of your eggs in one basket. Without the right asset allocation for your goals, you could easily end up losing too much money in a stock market drop, or you might not be able to build wealth at a fast enough rate to retire when you want.

During unsettled times, many people turn to cash for their retirement portfolios. Cash can help you with capital preservation. While you don’t want to rely too heavily on cash, since you won’t end up with enough yield to build wealth, it’s not a bad way to add a little safety to an investment portfolio that contains stocks and bonds. One way to add cash to a retirement portfolio is to invest in CDs.

CDs and Your Retirement Portfolio

CDs are sometimes considered a good choice for a retirement portfolio because it can be possible to get a higher rate of return on your cash than what you would get by keeping your money in a more traditional savings account. A long-term CD might offer a reasonable rate of return. However, there are some things to keep in mind.

First of all, you might not be able to hold a CD in the retirement account offered through your work. Most company 401(k) plans are focused on index funds. That’s fine┬ásince stock funds can be great additions to a retirement portfolio so that you can build wealth over time.

If you want to use a CD as part of a tax-advantaged retirement plan, you will need to open an IRA. If you have an Individual Retirement Account (and any American with earned income can open an IRA), you can check with your custodian to find out if you can add a CD in order to boost your cash holdings.

If you keep a CD in your IRA, it takes on the tax advantages that come with an IRA. If you have a Traditional IRA, the interest earned from your CD isn’t taxed until you withdraw it during retirement. If you have a Roth IRA, you won’t have to worry about paying tax on your interest earnings at all, as long as you withdraw your money in accordance with the withdrawal rules of the Roth IRA.

This can be a small advantage, since you normally pay taxes on interest earned from CDs in the year that it is paid to you. If you keep the CD in a tax advantaged IRA, this isn’t an issue.

However, it’s important not to rely too heavily on CDs because the yield usually isn’t enough to beat inflation, much less build wealth effectively.

The Role of CDs in a Retirement Portfolio

For those looking for a little cash to help prop up a retirement portfolio through diversity, CDs aren’t all bad. Additionally, if you can purchase CDs during times when the market is doing well and the yield is higher, the interest from your CDs can provide income during your retirement.

Some retirees like to build long term CD ladders to provide them with income over time. However, this only works if you already have a large nest egg and can divide your CDs into jumbo CDs that are large enough that the interest earned (and paid out) is significant enough to actually provide income. For some retirees, using CDs makes sense once they have quit their jobs. CDs can be used during the distribution phase of retirement, even though they aren’t that useful during the accumulation phase, due to their low rates of return.

While CDs can serve as part of a backstop in a portfolio, they are not ideal for the wealth building phase of your retirement. The interest yield on CDs is so low that you might actually be losing money, in real terms, to inflation. You aren’t going to build up a nest egg when you are lucky to earn between 1% and 1.5% on your CDs. Even during a high interest rate environment, CD rates rarely go much beyond a 5% or 6% yield. That can be a respectable return, but it will be many, many years before CDs ever return that much again — if they ever return that much again.

As inflation takes hold, your real returns from CDs are smaller and smaller. Once taxes are figured in, you could easily be losing money in real terms. You are actually more likely to succeed with your retirement portfolio if you consider your CDs as a cash safety net, and rely on stock funds for most of your growth, with some bonds for moderate growth plus a degree of safety. You are more likely to meet your retirement goals if you are diversified with your holdings and rely on CDs during retirement, rather prior to retirement when you are trying to build your nest egg.

In general, cash just isn’t the best choice for a retirement portfolio, particularly during the accumulation phase. While there is a place for cash assets like CDs in a long term retirement plan, it’s important to carefully consider the situation and figure out how CDs are most likely to fit in at different stages. Too much reliance on cash can mean that you risk your long term comfort during what should be your golden years.