Many people will agree that it’s never a good idea to put all your eggs in one basket when planning for retirement. So in addition to opening an employer-sponsored 401(k) plan through work, you might also open an individual retirement account (IRA) with a bank or investment firm.
These accounts aren’t investments, but rather holding accounts for various types of investments like bonds, mutual funds, and stocks. Of course, these aren’t the only investments you can have in an IRA. You can also use your account to invest in a certificate of deposit (CD).
When you open an IRA CD, you agree to leave your money in the account for a specific length of time in exchange for a higher rate of return. Certificate of deposit rates, on average, are higher than rates on savings accounts.
If you leave the money in the account until the CD matures, you’ll get all of your investment back plus interest.
How an IRA CD Differs From a Regular IRA?
It’s important to understand the difference between an IRA CD and a regular IRA.
An IRA CD is essentially a basic CD within a traditional or Roth IRA. Since a regular IRA is a holding account, you can sell securities within the account and use the proceeds to purchase other securities. This isn’t the case with an IRA CD. This is a standalone CD account. So if you cash out the CD, you’ll also close the account.
An IRA CD, however, is subject to the same rules as a regular IRA. So if you choose to withdraw or cash out funds from your IRA CD early, you’ll not only reduce the balance of your retirement account, you may have to pay an early withdrawal penalty and a tax penalty.
Maximizing the Growth of Your IRA CD
An IRA CD provides a safe way to diversify your retirement portfolio and receive a guaranteed return on your investment. In other words, you’re able to grow your nest egg while reducing some of your risks.
And unlike stocks and bonds, certificate of deposits within an IRA are FDIC-insured up to $250,000, providing added peace of mind.
With any type of investment, it’s important to maximize the growth of your account. To benefit the most financially from this particular type of investment, you’ll need to keep your cash in the account until the CD matures. And once the CD matures, either renew for another term, or keep all proceeds within the IRA.
What Happens When You Withdraw an IRA CD Early?
IRA CD terms vary, with some CDs reaching maturity after several months or several years. This is your money, and you’re allowed to withdraw cash from your IRA CD at any time.
But since an IRA CD cash out also involves a withdrawal from your individual retirement account, you could get hit with steep penalties.
If you’re under the age of 59 1/2 and make an early withdrawal from an IRA CD, you’ll pay a 10% early withdrawal penalty, as well as a tax penalty. The early withdrawal and tax penalty doesn’t apply to Roth IRAs. This is because contributions to a traditional IRA are tax-deductible, whereas you’ll pay taxes upfront with a Roth IRA.
Since you’ve already paid taxes on the latter, you can withdraw the amount of your Roth IRA contributions at any time with no penalty or tax. You will, however, pay penalties and taxes if you withdraw any investment earnings before you reach the age of 59 1/2.
But these aren’t the only costs you could face.
Remember, IRA CDs also have maturity dates. If you touch any funds in your account before the CD reaches maturity, your bank or investment firm may charge an additional CD early withdrawal penalty. This penalty is usually the equivalent of several months' of interest and applies even if you’re eligible for penalty-free IRA withdrawals.
IRA CD Maturity and Early Withdrawal Penalties
Renewal is one option once your IRA CD matures. Your investment firm or bank can use your CD proceeds to buy other securities within your IRA. Depending on the terms of your IRA CD, the account may automatically renew for a new term, at which point you’ll earn the current market rate.
But you don’t have to agree to an automatic renewal. IRA CD rates can vary from bank to bank. So after comparing your options, you might decide to reinvest proceeds in another IRA CD or another type of IRA for a higher return on your money. Before doing so, make sure you know how penalties work.
1. Direct Transfer
If you’re reinvesting in a different account, one option is a direct transfer to move funds from your old IRA CD to a new one. You’ll need to open an IRA with a new bank or investment firm and complete the necessary paperwork before the transfer of funds.
This method alleviates an IRA early withdrawal penalty because funds aren’t distributed (or never in your possession). Keep in mind, you’ll only avoid the penalty when transfers are completed “after” your CD matures. You’ll pay an early CD withdrawal penalty if your bank or investment firm initiates the transfer before maturity.
An IRA rollover can achieve the same outcome as a direct transfer. But unlike a direct transfer, a rollover does involve the distribution of funds. So you must adhere to specific rules to avoid an IRA early withdrawal and tax penalty.
You have 60 days from the time of distribution to deposit funds from an old IRA CD into a new IRA. If you don’t complete the transfer within the required timeframe, you could face an early withdrawal penalty. Be mindful of the fact that you’re only allowed one rollover every 365 days.
If you don’t deposit the funds in time, you’ll not only get hit with an early withdrawal penalty, you’ll also pay income tax on the distribution amount.
The early withdrawal penalty doesn’t apply to everyone in this situation. If you miss the 60-day cutoff for rolling over funds and you’re at least 59 1/2 years old, you won't have to pay the penalty. You’re old enough to take penalty-free withdrawals, but you may have to pay taxes on any amount you don’t roll over.
3. Complete liquidation
Another option after an IRA CD matures is complete liquidation of the account. In this case, you don’t transfer or rollover funds. But rather cash out the CD and receive your proceeds. Any proceeds you receive may be considered taxable income, and you’ll pay an IRA early withdrawal penalty if you’re under 59 1/2.
Currently, you’re able to contribute up to $5,500 each year to a traditional or Roth IRA CD. This is the most you can contribute, regardless of whether you take withdrawals from the account.
How Can You Avoid IRA CD Early Withdrawal Penalties
Touching an IRA CD early comes with a hefty price tag. But there are ways to soften the blow if you must tap the account before maturity, or before you’re eligible for penalty-free withdrawals. Although you can’t always avoid the tax penalty, you can sometimes avoid the early withdrawal penalty.
1. Penalty-free IRA CD
Ask your investment firm or bank about penalty-free CDs before including a CD in your individual retirement account. This option lets you tap funds in the CD early without penalty. The downside is that these CDs often come with lower interest rates.
2. Death or incapacitated
Your bank or investment firm may also waive the early withdrawal penalty if you die or if you’re declared incapacitated. In the event of death, the penalty is also waived if a beneficiary cashes out funds in an IRA CD.
It’s also worth noting that you can withdraw cash from your individual retirement account before the age of 59 1/2 and avoid early withdrawal penalties under certain circumstances. You might be able to withdraw cash penalty-free to:
- Pay a hospital bill that exceeds 10% of your income
- Pay health insurance premiums cover the cost of college tuition
- Cover the cost of college tuition
- Buy a home (if you’re a first-time homebuyer)
- Pay off an IRS tax debt
An IRA CD is another way to diversify your retirement portfolio with little out-of-pocket and risk. But if you open this type of investment, only do so if you can commit to keeping your money in the account until the CD matures, and until you’re at least 59 1/2. Tapping the cash sooner will reduce the balance of your retirement portfolio. This will make it difficult to reach your long-term financial goals.
As mentioned before, this is one of the safest ways to increase your retirement savings. Even so, IRA CDs don’t offer the same return as stock, bonds, real estate, and other securities because they have lower interest rates. Therefore, these investments might be more suitable for those close to retirement, and too conservative for younger investors.