What is an IRA certificate?

An individual retirement account (IRA) offers a great to save for retirement without going through your employer. It allows you to invest in a wider pool of investment options such as stocks, bonds, mutual funds, etc. What many investors do not know is that they can also use their IRA funds to invest in Certificates of Deposit (CD).

An IRA certificate, also known as IRA CD, is an IRA that invests in certificates of deposit. It provides a fixed interest on your money for a set maturity term, usually between 6 months and 10 years. You can open an IRA CD with a credit union, bank, and brokerage account. For 2022, you can contribute up to $6,000 to an IRA CD, or $7,000 if you are above 50.

How IRA Certificate of Deposit Works

IRA CDs are similar to certificates of deposit (CDs), but the former is specifically designed for retirement. When you purchase a CD, you will hold the instrument over a set maturity term in exchange for a fixed interest income. Investing in CDs can help you diversify your retirement portfolio and provide a stable income that is not affected by stock market volatility.

When using an IRA to invest in CDs, it means you are using your retirement savings to invest in low-risk CDs in exchange for a fixed return on your retirement money until it matures. Usually, when investing in CDs, you can choose the maturity term of the CD, which can vary from 6 months to 10 years or more.

Unlike the regular CDs where the interest income is taxed in the year you receive a payout, an IRA CD defers taxes until when you make a withdrawal. By deferring taxes, you allow the money more time to grow and earn a return. Once the CD matures, you can choose to renew it for a new maturity term or use the money to invest in stocks, bonds, or other investment options available in your IRA.

Types of IRA Certificate of Deposit

Here are the main types of IRA CDs that you can open:

Traditional IRA CD

A traditional IRA CD is funded with pretax dollars. The contributions and any returns earned from the certificates of deposit grow tax-deferred until retirement. You will only pay taxes when you withdraw money from the account. If you withdraw funds before the set maturity date, you could pay penalties to the bank or the IRS for early withdrawals before 59 ½. 

SEP IRA CD

If you are self-employed, a business owner, or a freelance contractor, you can open a SEP IRA CD with a bank, credit union, or brokerage. It is similar to a traditional IRA, and it is funded with pre-tax contributions.

Roth IRA CD

A Roth IRA CD is funded with post-tax dollars, and the money grows tax-free over your working years. You can withdraw the portion of contributions at any time tax-free. However, you can only withdraw the earnings tax-free if you are above 59 ½ and the account is at least five years old.

IRA CD vs. Certificate of Deposit

One of the key differences between an IRA Certificate and a certificate of deposit (CD) is the amount you can invest. With an IRA CD, there is an annual contribution limit that you should not exceed, while a CD has no limit on the amount you can deposit in a year. You can contribute up to $6,000 to an IRA CD in 2022, or $7,000 if you are above 50.

An IRA CD and CD also differ in early withdrawals. If you make an early withdrawal from a CD before the set maturity, you will pay a penalty to the bank. In comparison, early withdrawals from a traditional IRA CD may be subject to a double penalty from the bank and the IRS. The IRS imposes a 10% early withdrawal penalty for withdrawals made before 59 ½.

Pros of IRA CDs

Safe and stable return

When you invest in an IRA certificate, you get a guaranteed stream of fixed income over the CD term. If you invest in FDIC-insured CDs, your principal amount is insured for up to $250,000 in the event of bank failure.

Low fees

When you use your IRA funds to invest in CDs, you will enjoy low fees as compared to the fee you would have incurred when trading stocks. Also, you don't need a broker to manage your investment.

Short-term income

If you are approaching retirement, and you want a mix of conservative investments to earn short-term income, CDs are a good option. IRA CD can generate a predictable income in the short term.

Cons of IRA CDs

Limited earnings

Though CDs are considered a relatively safe investment, they pay near-zero returns, usually a small percentage above the current rate of inflation. Minus inflation, you will earn a relatively low return.

Funds are locked up till maturity

IRA CD pays a fixed interest rate throughout the term, and you risk missing out on opportunities to earn high interest. If the interest rates were to increase during the CD term, you will be locked into the fixed interest rate.

Early withdrawal penalties

When you invest in an IRA CD, you cannot access your money before the set term expires. If you want to access your IRA CD funds before the set maturity term, you will pay an early withdrawal penalty. There is an additional 10% early withdrawal penalty if you are younger than 59 ½ at the time of withdrawal.