CDs are great for term short-term savings for major purchases (but not if you’re in a high tax bracket).
CDs are safe because of FDIC insurance, but they are not completely risk-free.
A diversified portfolio of stocks and bonds is still a better option for a long-term investment strategy.
As I drive around town, I have noticed over the past few months that many banks are advertising certificates of deposit (CDs) at about a 5% interest rate. CDs are short-term bonds (fixed income) issued by banks. They pay a certain amount of interest over a specified period of time. While it may be tempting to take advantage of those attractive rates after so many years of banks paying very little, CDs should not be used in place of stocks or bonds when constructing a diversified portfolio. A 5% CD is great if you need to set aside cash for six to twelve months in preparation for a large purchase (buying a house, taking a big overseas trip, etc.). Just remember, even though they are FDIC insured, they’re not entirely risk-free.
First, there is a re-investment risk. It’s great you have a 5% rate locked up for the next six to twelve months, but where will rates be a year from now? The Fed is likely to end its aggressive rate hiking cycle later this year and could start lowering rates soon thereafter. Most of the highest-yielding on the market today are in the 6-to-18-month range. There’s a good chance you’ll be forced to reinvest your CD at a lower rate or make another tough decision about your cash when that CD matures. Also, some banks will automatically renew your CD if you don’t get in touch with them promptly. Then you’re locked up at some other unknown rate in the future that might not be what you wanted.
Also, after-tax returns matter. Most of you reading this blog are in higher income tax brackets. You pay federal and state income tax (depending upon where you live) on the interest from CDs. Interest earned on CDs is taxed at ordinary income rates, which can be as high as 37% at the federal rate alone, plus as much as 10.75% additionally in New Jersey or 3.06% in Pennsylvania. Municipal bonds, which are generally federal tax-free (and sometimes state tax-free) may be more advantageous for many investors on an after-tax basis.
Inflation risk. Inflation is still higher than it has been in recent years. It’s eating away at your purchasing power as well as the returns on your fixed-rate investments such as CDs. If you want better protection against inflation, you may need to take some risks with stocks. This is especially true if don’t need your money anytime soon.
What is the best way to own CDs? CDs are FDIC-insured (up to $250,000). If you want to put more than $250,000 into CDs, you should buy multiple bank CDs through your brokerage account, which would all be FDIC-insured (up to $250,000). That’s a lot more efficient than opening CDs at different banks all across town and trying to keep track of them. We help our clients purchase multiple CDs when appropriate. We understand how to evaluate different banks for stability and security and will make sure your CDs are never automatically renewed.
Review Financial Planning Basics
CDs fit best as part of a cash flow plan as opposed to an investment plan. In a cash flow plan, you have your normal checking account balance and your emergency fund in a savings account (or money market). Then you should set aside more cash for large known expenses coming up over the next year. CDs and short-term municipal bonds (if you are in a high tax bracket) are good investment vehicles for setting aside cash for these expenses. Just don’t use CDs to replace a stock and bond portfolio. It’s better to invest in a diversified portfolio of stocks and bonds that are consistent with your goals and risk tolerance.
What’s next for interest rates?
The US Treasury yield curve is sloping downward. This means the bond market is telling us that rates are expected to be lower in the future. Even though the market is expecting two more rate hikes by the Fed this year, looking out into the future, rates will most likely be lower. You don’t want to be stuck with a reinvestment decision at lower rates. It may make sense to buy new bonds that pay more for longer (a diversified bond portfolio) if cash isn’t known to be needed.
Just as we’re always advising clients not to try to time the stock market, don’t try to time future changes in interest rates. No one can predict the future. In today’s interest rate environment, I would much rather see someone who has a retirement income need over the next five to ten years take on more risk through a well-diversified stock and bond portfolio. CDs are best used by those in a low tax bracket as a way to save for known large expenses coming up in the next year.
Conclusion
If you or someone close to you has questions about CDs or about establishing a cash flow plan as part of a comprehensive financial plan, please don’t hesitate to reach out. We are happy to help.
RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth