Comparing CD and Money Market Accounts
When it comes to money that you may have to tap soon, it’s usually best placed in a conservative type of investment. For example, your emergency funds should be in an account that won’t drop in value when you need to cash it in. This can also apply retirement savings as your prepare to leave the workforce, or to college savings accounts as your child approaches high school graduation.
Because of their low-risk nature, cash accounts such as money market accounts and CDs can offer help protect your savings in situations like these. But it’s important to understand how these types of deposit accounts work before you decide which is right for you.
What are certificates of deposit (CDs)?
A certificate of deposit (CD) is a contract with a financial institution, paying a contractual rate of interest, that you buy for a specific term raging from three months to several years. Here are some of their key features:
- CDs always require a minimum time commitment. It’s important to consider your present and anticipated financial needs when deciding how long to invest in a CD. Some investors choose to buy multiple CDs with terms of varying lengths, which maximizes liquidity. This strategy is called “laddering.”
- CDs come in many varieties. You may encounter fixed-rate CDs, variable-rate CDs, or even CDs that protect heirs from paying early withdrawal penalties. Read the fine print for any CD you’re considering. It’s essential to know all of the terms applicable to your CD.
- FDIC-insured CDs offer strong security. Unlike stocks and mutual funds, the FDIC protects the CDs it insures up to a maximum of $250,000 per depositor per institution.
- Early withdrawal penalties may apply. Make sure you understand the amounts and terms for penalties assessed before investing.
- Your yield will vary with your commitment. In general, the more you invest, and the longer you invest it, the better the return.
If you’re not able to tie up large sums of money for long periods of time, a money market account can help you save while offering more liquidity. When considering which is right for you, shop around — sometimes institutions that want to attract new customers will offer exceptional rates on money market accounts that may allow you to get a better return without tying up your funds.
What are money market accounts (MMAs)?
If you’re not able to tie up large sums of money for long periods of time, a money market account can help you save while offering more liquidity. Money market accounts typically bear strong similarities to interest-bearing checking accounts and savings accounts. Here are some of their common components:
- They are also secure. Like CDs, money market accounts from FDIC-insured institutions bear very little risk for deposits up to $250,000.
- They may offer attractive yields. MMAs generally pay higher interest rates than regular checking or savings accounts, combining the advantages of easy access with a rate of return comparable to some investment products.
- Your rates will vary with the market. Money market account interest rates tend to follow short-term market interest rates.
- They usually have minimum opening deposits and balances. You may have to come up with a fairly large deposit to open an MMA. You may also have to maintain a minimum balance to avoid a monthly fee.
- They are different from money market funds. Don’t confuse money market accounts with money market mutual funds, which are not FDIC-insured. Money market mutual funds are investment products and may carry some of the risks associated with investing in the stock market.
Whatever your choice in asset-preservation investments, it’s important to check rates and terms on both CDs and MMAs. While it is generally true that tying your money up longer gets you a higher interest rate, that’s not always the case. So shop a bit to ensure that you are safely maximizing both your liquidity and your rate of return.
Frequently Asked Questions
Q: Are there any tax consequences if I transfer money out of a money market fund or a money market account and into a long term CD?
A: This should be no problem, assuming the money is in an ordinary taxable account. If it is in a tax-advantaged vehicle like an individual retirement account (IRA), make sure the certificate of deposit (CD) is also within the IRA, or rolled into another IRA.
Interest held in a money market account is taxable in the year in which it is earned. So if you close the account, just remember that you will have to include any interest earned so far this year on your 2016 tax return.
As you contemplate the switch from a money market account to a CD, take some time to think about how to make this move fit with your eventual financial goals for the money.
How to evaluate financial needs and tax status for CDs
The first thing to think about is whether you are saving this money for some particular upcoming need, or generally for retirement. If there is a specific need on the horizon, that will help determine what length your CD should be, whether a long term CD or a short term CD.
If you are shifting this money into a long term CD because you are saving for retirement, you might consider shifting it into a Roth IRA. Assuming this is currently a taxable account, putting the money in a Roth IRA won’t provide any tax advantage in terms of the principal you deposit. However, it will allow the account to earn interest tax-free until you withdraw money from it. Be advised, though, that there are income restrictions and contributions limits that determine whether and how much you can contribute to a Roth IRA.
What to look for in a CD
Whether or not you move the money into an IRA, identifying the purpose of this money will help guide your search for the right CD.
Here are four things to consider as you make that search:
If you have an upcoming need for the money, that may determine the length your CD should be. Otherwise, since CD rates are generally higher on longer deposits, longer is better unless you think a rise in interest rates is imminent.
2. Laddering opportunities
If you have a series of different needs or want to hedge against interest rate changes, you might want to consider a CD ladder, which is a sequence of CDs with different maturity dates.
3. High Yield
Once you have decided on CD length, shop around to find the highest yield being offered at that length.
4. Low early withdrawal penalty
CDs carry a penalty for withdrawals made before the maturity date, but the penalties vary. Assuming the yield is competitive, look for a CD with a relatively low penalty because that will give you some flexibility if there is a significant move in interest rates.
Finally, in a few years when the maturity date of this CD is approaching, you should consider these issues anew with respect to your next CD, rather than letting the existing one roll over automatically at the same length and the same bank.