If you're looking for a way to get a decent return on investment without exposing yourself to too much risk, a certificate of deposit could be a good choice. Certificates of deposit offer investors the opportunity to generate a higher return on their money than the average savings account offers.
Certificates of deposit
Also known as a CD, a certificate of deposit is similar to a regular savings account in that you put money in a bank and earn interest at the going rate. But whereas a regular savings account lets you withdraw your money whenever you want to, with a CD, you're committing to locking up your money for a specified period of time. That period could be six months, one year, two years, or longer. In exchange for that extended commitment, you'll be rewarded with a more generous interest rate. Plus, like a savings account, when you open a CD, there's no risk of losing money provided you invest it at a bank that's FDIC-insured. For 2016, the FDIC insurance limit is $250,000 for a single depositor and $500,000 for a joint account shared by two depositors. As long as you don't exceed these limits when opening your CD, you won't lose any of your principal.
However, there is a major downside to CDs. If you withdraw your money before your CD comes due, you'll incur a penalty, the exact amount of which will depend on your bank and the length of your CD. For CDs with a maturity of one year or longer, the typical early withdrawal penalty is six months' worth of interest. For CDs with a maturity of less than one year, the typical early withdrawal penalty is three months' worth of interest.
IRA certificates of deposit
Did you know you can also use an IRA to open a CD? (Our IRA Center can answer lots of your questions about these investing instruments.) An IRA CD works just like a regular CD, only instead of using money from a savings or checking account to open the CD, you invest money from your IRA. If you have cash sitting in your IRA already, you may be able to open a CD directly through your brokerage firm, just as you'd be able to use that cash balance to invest your IRA dollars in stocks or bonds.
The penalty for cashing out an IRA CD early is generally the same as the penalty for doing so with a regular CD. However, if you begin taking required minimum distributions from your IRA at age 70.5, which the IRS mandates, and those distributions result in an early cash-out of a CD, some banks may waive the associated early withdrawal penalty.
If you withdraw money from an IRA CD before it comes due and before you reach 59.5, the minimum age at which you're allowed to take money out of your IRA, you'll most likely face an early withdrawal penalty from your bank. If you take the proceeds from that cash-out and transfer them to another IRA, then that early withdrawal penalty from your bank is the only one you'll face. But if you withdraw those funds and don't roll them into another IRA, you'll face a 10% IRA early withdrawal penalty as well.
Whether you decide to open a CD for general savings purposes or to help grow your retirement savings, your best bet is to make sure you're able to leave that money tied up for the entire duration of the CD. Otherwise, the penalties you face could significantly reduce or wipe out whatever return you would've otherwise generated.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.