Beginning in March 2022, the Federal Reserve began raising interest rates in an attempt to mitigate high inflation. Over the course of the last two years, the Federal Reserve has raised interest rates 11 times resulting in targeted interest rates that are 5.25% higher than they were at the beginning of 2022.
While the aggressive rate increases have substantially impacted the cost of borrowing (i.e. mortgage rates have increased from under 3% for most of 2021 to nearly 8% in recent months), it has also resulted in an increase in the interest rate paid to individuals who invest in fixed income investments such as certificates of deposit (CDs), bonds, and savings accounts.
With the increase in CD rates, the advertisement of CD specials has exploded with nearly every bank marketing their attractive CD rates to the public. Naturally, this has led many individuals to ask the question whether CDs are right for them.
How Certificates of Deposit Work:
To start it is important to understand what a CD is and how it works. A CD is a deposit that an individual makes with a financial institution for a specified period of time. CDs come in various maturities allowing individuals to tailor the investment to a specific time horizon and lock in the interest rate they will receive.
CDs qualify as deposits covered by FDIC insurance (subject to the typical FDIC insurance limits). Funds invested in CDs do not fluctuate like investments in actively traded securities like stocks and bonds. As a result, CDs are viewed as very low risk investments.
Since CDs are purchased in specific time increments such as 3 months or 5 years, banks will often pay a higher interest rate on CDs than on unrestricted deposits. The additional certainty of having the CD funds locked up for a set period of time provides value to the bank and as a result the bank will typically pay a higher interest rate for that certainty. Regardless, it is important to note that individuals willing to shop around can often find high yield savings accounts paying similar rates to CDs.
Because CDs have set maturity dates, individual are not allowed to withdraw their funds early without consequence. CDs typically have early withdrawal penalties that are often expressed as forfeiting the last 3 or 6 months of interest. Accordingly, individuals can generally access funds in a CD if an emergency arises, but that early access will come at a cost.
Once an individual purchases a CD, they will also have to consider the tax implications. Interest income earned on CDs is treated as ordinary income for both state and federal tax purposes. The following graphic shows both the pros and cons of CDs.
Key Takeaway:
CDs are time deposits that are covered by FDIC insurance (subject to limits) and often offer a better interest rate than standard checking and savings accounts.
When Do Certificates of Deposit Make Sense:
Whether a CD makes sense for an individual’s specific situation depends on the facts and circumstances. Currently (December 1, 2023) one-year CD rates are in the range of 5.0-5.5% which is much higher than what many individuals are receiving on their checking and savings account balances.
For individuals who need to keep cash available for a known amount of time (i.e. upcoming down payment on a home, purchase a vehicle, etc.), a CD can be a simple and safe way to earn a better rate of return until they need their cash.
If, on the other hand, an individual knows they will need cash, but doesn’t know the exact timing of that need, choosing a CD with a specific term can be a challenge. In cases like this, it may make sense to consider alternatives such as a high-yield savings account.
Key Takeaway:
CDs represent a simple way to earn a better rate of return on cash, but their downsides include penalties for early withdrawal and inefficient taxation.
Alternatives to Certificates of Deposits:
High Yield Savings Accounts (Better Liquidity): High yield savings accounts are also covered by FDIC insurance resulting in the same protections as a CD without the time restriction. Certain high yield savings accounts are currently (December 1, 2023) offering interest rates around 5%. In cases where a CD and a high yield savings account are offering the same interest rate, generally the high yield savings account makes more sense given the funds can be withdrawn without penalty.
When opening a high yield savings account, it is always important to read the fine print to understand whether the advertised rate applies to the entire balance or whether there are exceptions.
US Treasuries (Better Tax Treatment): Individuals who are comfortable having their funds restricted for a set period of time could also consider purchasing US Treasuries. US Treasury bills, notes, and bonds are debt obligations backed by the full faith and credit of the United States government. They come in original maturities ranging from 4 weeks to 30 years, and are actively traded and highly liquid allowing investors to cash out their investment as needed.
Since US Treasuries are actively traded, their price can fluctuate, but for individuals purchasing short-term maturities as a way to park cash for less than a year, fluctuations are generally minimal. Investors that hold the investment until maturity will receive the full principal value at that time regardless of fluctuations in value over the life of the investment.
Currently (December 1, 2023) one-year US Treasuries are yielding between 5.0-5.5% which is comparable to CDs, but one of the primary benefits of US Treasuries is that the interest income is exempt from state income taxes. For individuals living in high tax states such as Minnesota, this can make a significant difference on the after-tax return experienced by an investor.
For example, if we compare a CD and US Treasury obligation on a standalone basis that are both offering a 5% interest rate, the after-tax return for a Minnesota taxpayer who is in the top 40.8% federal (37% Ordinary + 3.8% Net Investment Income Tax) and 9.85% MN tax bracket would be the following:
- CD = 5% x (100% – 40.8% – 9.85%) = 2.47% after-tax return.
- US Treasury = 5% x (100% – 40.8% – 0%) = 2.96% after-tax return.
As shown, the US Treasuries result in nearly 0.5% additional return simply by purchasing an investment that receives better tax treatment from the outset. Accordingly, individuals with significant income living in high tax states may want to consider purchasing US Treasuries as a way to more effectively earn a return on their cash balances until the cash is needed.
Municipal Bonds (Also Better Tax Treatment): Another option, although more complex, would be buying municipal bonds offered by states, cities, counties, or other governmental entities. Municipal bonds can be purchased with remaining maturities to match an investor’s time horizon.
Municipal securities are not backed by the full faith and credit of the US government. Instead, they are typically backed by the governmental entity that issued them, although some are backed only by the revenue from the specific projects they were issued to finance. Accordingly, understanding the credit protection of each specific municipal bond is very important.
The benefit of municipal bonds is that their interest income is exempt from federal income tax and often state income tax as well if the investor resides in the state where the bond is issued. Because of these factors, municipal bonds pay a lower interest rate, but on an after-tax basis, returns are often better for individuals in high tax brackets.
For example, AAA rated municipal bonds with one-year remaining maturities can be purchased with interest rates near 3.8% (December 1, 2023). Given the interest is exempt from federal taxes and may also be exempt from state taxes depending on the investor’s specific situation, a 3.8% after-tax return may be attractive; however it is important to keep in mind that the higher after-tax return may also reflect a slight increase in credit risk of the issuer.
Key Takeaway:
Individuals who may need their cash at any time or are in high tax brackets can often benefit from considering alternatives to CDs such as high yield savings accounts, US Treasuries, or municipal bonds.
What Role Does Fixed Income Play In A Broader Plan?
Fixed income assets like CDs, high yield savings accounts, US Treasuries, and municipal bonds can be an important part of an individual’s portfolio. However, it’s important to remember that fixed income assets should be part of a broader plan rather than the entire plan itself.
With the higher interest rate environment today, some individuals consider purchasing CDs or US Treasuries to earn a safe 5% return at the exclusion of all other investments. While this approach preserves the investor’s initial principal and is therefore considered “safe” by the investor, it ignores what is often a bigger risk – lost purchasing power over time due to inflation.
For example, using the after-tax return on the 5% CD we calculated above which was 2.47%, we can consider how inflation can flip the “real” return to less than zero and result in a loss of purchasing power. For the 12 months ended October 2023, the Consumer Price Index for All Urban Consumers (CPI-U) showed that the annual inflation rate was 3.2% – and was as high as 9.1% in June 2022.
Accordingly, an investment that only earns 2.47% after tax would fail to maintain its purchasing power in this environment. While fixed income investments like CDs and US Treasuries can feel safe because the principal will be returned with interest, over the long-term, the more likely result is lost purchasing power on an after-tax basis as inflation erodes the value of each individual dollar.
On the other hand, many investments that fluctuate more in the short-term (US and international equity, real estate, etc.) have provided meaningful inflation adjusted returns over time. For example, the S&P 500 has generated approximately 10% annual returns since 1926. While these returns vary significantly from year to year, over long periods of time, they historically produce significantly better results than fixed income.
Key Takeaway:
Low-risk, fixed income investments generally provide minimal inflation adjusted returns after taxes are considered for high-income taxpayers.
Given the challenge of generating real inflation adjusted returns on an after-tax basis from many low-risk fixed income investments, it is important to construct a portfolio that can provide real long-term results while still balancing the need for stable assets to cover known distribution needs in the short-term.
Because markets fluctuate and because we know that there will be market downturns in the future (we just don’t know when), it is important to use fixed income – regardless of whether it is CDs, US Treasuries, municipal bonds, etc. – primarily for three purposes:
- First, fixed income can be used as a way to keep a portion of the portfolio stable so that during times of market downturns, cash can be drawn from the more stable fixed income investments so that the other investments have time to recover. Accordingly, a conservative fixed income position should be considered to cover any distributions that may need to be withdrawn within a 2-7 year period in the event that there is a market downturn.
- Second, fixed income adds diversification that can moderate fluctuations within a portfolio. This can increase the ability of investors to ride out market downturns without bailing on their investment plan altogether. Investors that struggle watching their investment balances fluctuate should consider an allocation to fixed income to decrease the odds that they bail on the plan at just the wrong time.
- Third, fixed income can help investors systematically buy low and sell high through scheduled rebalancing. Given fixed income is generally more stable than other asset classes, when the market declines fixed income investments will represent a larger portion of the portfolio. To keep the fixed income allocation in line with targets, it is important to sell some of the fixed income and purchase the investments that have declined in value. In other words, selling the assets whose price has remained high, and buying other assets that have gone down and presumably are undervalued.
How important each of these factors is to a specific individual’s situation depends on their unique facts and circumstances; however rarely is it appropriate for an individual to fully abandon their overall investment plan to purchase all fixed income investments – regardless of whether that is CDs, US Treasuries, municipal bonds or any other fixed income investment.
Key Takeaway:
Fixed income can be an important part of an individual’s investment plan, but rarely is it appropriate for fixed income to play the entire role.
Conclusion:
With the increase in interest rates since the beginning of 2022, CDs are once again paying meaningful interest rates. With higher rates comes significant advertising and promotion that is impossible to ignore.
CDs have their place and are typically the best fit for individuals who will need to invest a specific cash balance for a known period of time, would like to earn a better interest rate than simply having the cash sitting in a traditional bank account, and cannot withstand even minor fluctuations in the principal balance.
For individuals who either may need their cash at any time or can withstand small fluctuations in value day-to-day, there are other options that offer better liquidity or better tax treatment that can be considered.
Before purchasing CDs, it usually makes sense to take a step back and assess how the CD fits into your overall investment plan and whether there are more attractive options that can fulfill the same purpose.
If you are curious about CDs or your overall investment strategy, our Family CFOs can answer your questions and help you create a plan to determine what is best based on your unique goals and circumstances. If you are interested in learning more, we would love to connect to see if what we do is right for you.
