The 5 Biggest Downsides of CD Investing

Certificates of deposit (CDs) are a popular "set-it-and-forget-it" way to earn interest with almost zero risk. Today, you can lock in a 14-month CD and earn a guaranteed 4.25% APY -- not bad in today's uncertain economy.

But CDs certainly have some sneaky downsides.

Here are five potential pitfalls to look out for (and how to find today's top APYs without getting burned).

1. You'll pay a penalty if you withdraw early

All CDs come with a maturity date. And if you need your cash before that date, you'll probably be penalized with a fee.

Banks typically charge several months' worth of interest if you withdraw early. For longer-term CDs, you could lose six months to a year of earnings, or even some principal if you pull out early.

This is why CDs work best for money you won't need anytime soon. Like funds for a house down payment in a couple years, or a portion of your emergency fund.

But if you're not totally sure when you'll need access to your cash, high-yield savings accounts (HYSAs) are a good alternative (this is where I keep my short-term cash pile). Many online banks are still paying rates close to 4.00% and let you withdraw whenever you want.

2. Returns may not keep up with long-term investing

Yes, CD rates are much better than they used to be. But they still fall short when compared to the long-term average of the stock market.

Over its long history, the S&P 500 has delivered an average 10% annual rate of return. Compare that to even a great CD paying an APY of 5.00%, and you're missing out on huge growth over long periods of time.

I realize this is comparing apples to oranges. CDs are safe and conservative, and the stock market carries much higher risk.

But it's always worth reviewing your long-term goals and making sure you're only using CDs for the right buckets of money. Like short-term savings or conservative portions of your portfolio.

3. CD interest is taxable income

Unless you hold your CD in a tax-advantaged account like a Roth or traditional IRA, the interest you earn will be taxed as ordinary income.

This can shrink your effective yield -- especially if you're in a high tax bracket.

Let's say you earn $2,000 in CD interest and fall into the 24% federal tax bracket. You'll owe $480 in taxes, reducing your net return to $1,520. Or even less if you owe state taxes also.

Paying taxes isn't necessarily a deal breaker for CDs. It's just one of those sneaky details that can cut into your returns if you're not expecting it.

4. Watch out for auto-renewals and grace periods

Here's something most people miss… When a CD matures, it usually auto-renews into a new CD with the same term -- sometimes at a much lower APY.

You'll usually get a short grace period (like seven to 10 days) to take action. If you don't, you're locked in again.

To avoid this, try planning ahead by:

• Marking your calendar with your CD's maturity date.
• Set a reminder a week before on your phone.
• Decide in advance how you're going to use the money when it matures. You can cash it out, roll it into a better-paying CD, or move it elsewhere.

If you're opening a CD online, it's easier to track everything digitally. Some banks alert you with renewal notices and maturity alerts.

5. Not all banks offer top-tier CD rates

Did you know the national average APY right now for a 12-month CD is just 1.63%? Meanwhile, some top online banks are offering 4.00% APY or higher for the same terms.

It really pays to shop around. You could seriously double -- or even triple -- your returns just by picking a better bank.

If you're going to lock up your money for months (or years), make sure you're actually getting paid well for it.

CDs can be useful, but only when they truly fit your goals. And like anything in personal finance, the details matter.