Individual retirement accounts (IRAs) are designed to help people save for retirement. By their nature, they are designed for long-term savings. Certificates of deposit (CDs) are a type of deposit account that is designed to give you a specified rate of return on your money over an amount of time.
Given that both are designed for long-term saving, they pair together naturally -- in the form of an IRA CD.
People often use CDs as collateral when they apply for a loan. The money in the CD serves as a guarantee to the lender that you’ll pay back the loan. It’s natural to wonder whether you can use an IRA CD as collateral, but you cannot. The restrictions surrounding IRAs make CDs held in an IRA unusable as loan collateral.
How Regular CDs Are Used as Collateral
First, let’s discuss how CDs are involved in loans at all.
When you apply for a loan, the lender has to decide whether or not to offer the loan to you. To do so, the lender will try to gauge whether or not you’ll pay the loan back. If you do make your monthly payments, the lender will make money from the interest you pay. If you stop making payments, the lender will lose money.
Some loans and credit lines, like mortgages or car loans, are secured loans. That means that there is an asset behind the loan that serves as security for the lender. If you stop making payments on your mortgage, the bank can repossess the house you bought with the loan, and sell the house to recoup its losses. If you miss payments on your car loan, the bank can do the same to your car.
Other loans and lines of credit, like most credit cards, are unsecured loans. If you stop making payments on an unsecured loan, there’s no asset for the bank to repossess and sell to recover its losses. That makes unsecured loans riskier for the lender. If the lender needs to try to recoup losses, it will have to bring you to court. That’s why unsecured loans, like credit cards, charge more interest than secured loans, such as mortgages.
Some loans, like personal loans, can be either secured or unsecured. When you apply for a personal loan, you can choose whether to apply for a secured or unsecured personal loan.
Why would you need a secured loan?
You may choose to apply for a secured personal loan because you have poor credit. Opting for a secured loan can improve your chances of approval. Secured loans also charge less interest, so going that route can help you save money over the life of the loan.
Unsecured loans don’t require you to put down anything up front, which can be a benefit in itself, but they’re harder to qualify for and more expensive.
Lenders often use CDs as collateral for secured loans for a number of reasons.
The first is that many lenders are also banks that accept deposits. The bank will offer you a loan if you open a CD with the bank. That means the lender holds on to the collateral, making it easy for them to take possession of should you default.
Another thing is that CDs have set terms, ranging from months to years. Loans also have terms that generally range from one to a few years. You can open a CD with the same term as your loan so that the money in your CD will become available when you pay off your loan.
Borrowers might offer a CD as collateral for a loan for a number of reasons in addition to the previously mentioned reasons, improving odds of loan approval and reducing the interest rate.
One reason is that opening a secured loan can help you rebuild your credit. If you make every payment on time, it will go a long way towards improving your credit score.
Another reason is that the money in your CD will continue to earn interest, so you’re not sacrificing potential return by offering it as collateral.
Why IRA CDs are Different
IRA CDs are quite similar to normal CDs but have a few key differences that make them unsuitable for use as loan collateral.
IRAs are designed to for retirement savings. Therefore, you're not supposed to access the money in them until you reach retirement age. There are also limits to how much you can contribute to an IRA each year.
You may contribute up to $5,500 to an IRA each year. If you do, you can deduct that amount from your income when you file your taxes. This gives immediate savings when you make contributions.
Once the money is in your IRA, you cannot withdraw it until you turn 59½. When you do withdraw, you pay taxes on the withdrawals. If you withdraw the money before turning 59½, you’ll have to pay a 10% penalty on top of the tax penalty.
These restrictions make CDs inside IRAs unsuitable as collateral for loans. You may not be able to get enough into an IRA CD to satisfy the collateral requirements.
Less security for lenders
Another reason IRA CDs aren’t suitable collateral is the protections they receive from creditors. The government wants people to have money when they retire so that they are unable to support themselves. For that reason, the Bankruptcy Abuse Prevention and Consumer Protection Act protects IRAs from creditors who are pursuing you for payment.
When the law was enacted in 2005, it protected up to $1 million in IRAs from being seized by creditors in bankruptcy. That amount has increased with inflation and is now close to $1.25 million.
Because the lender cannot seize the funds in an IRA CD unless your total IRA balances exceed that amount, IRA CDs don’t provide any security to lenders.
What You Can Do to Get Money from an IRA CD
If you really need cash and have an IRA, there are still some things you can do to get the money you need.
The first thing to do is to check whether your money is in a traditional IRA or a Roth IRA.
- Traditional IRA: You’re going to pay a lot to get the money out of the account. You’ll have to pay income tax on any amount you withdraw, which can cut 25% or more off the top. You’ll also have to pay a 10% early withdrawal penalty by the IRS.
Roth IRA: Roth IRAs provide tax benefits that are the reverse of the traditional IRA’s benefits. Instead of deferring tax on your income until you withdraw the money from your IRA, you pay the tax up front. When you later withdraw money from your Roth IRA, you won’t pay any tax on the money, including the earnings. Given a long time to grow, you can earn thousands of dollars in returns on your investment, and never pay a cent in tax.
Because your contributions to a Roth IRA are taxed up front, you can withdraw contributions from a Roth IRA without paying a penalty. This applies only to contributions. You’ll still pay a penalty to withdraw earnings on your contributions.
In either case, the biggest issue is that any money you withdraw from an IRA can never be put back in. If you’re young, even a small withdrawal can cause a big reduction in your account’s balance when you reach retirement. Withdraw just a little bit now could mean you have thousands of dollars less in the future.
Early withdrawal penalties may apply
Another thing to consider is the fees to withdraw money from an IRA CD. If you don’t wait for the CD in your IRA to mature, you’ll have to pay an early withdrawal fee on that, on top of the IRA penalties. CD early withdrawal fees are usually a certain number of months’ interest. If you withdraw the money from a CD early in its term, you could wind up with less than you deposited.
CDs are commonly used as collateral for personal loans, and people who like the idea of slow and steady returns often open CDs in their IRAs. This combo makes it easy to think that using an IRA CD as collateral for a loan would be the best of both worlds. Unfortunately, the many restrictions and laws surrounding IRAs make them unsuitable for use as loan collateral.