What Is A CD?

A certificate of deposit (CD) is a type of savings vehicle offered by most banks and credit unions.

Typically, when opening a CD account, you deposit money into the account in a lump sum (rather than adding money as time goes by, as with a savings account). Also, unlike a savings account, CD holders agree to leave their money in the account for a specified length of time — typically, six months to five years[1]. Some banks offer CDs with shorter or longer terms.

Once the CD matures — meaning that the specified term has ended — you can withdraw your money plus the interest that has built up in the account. In most cases, if you decide to withdraw your cash before the CD matures, the bank will charge a penalty fee, or you could lose your earned interest[2].

In return for holding your money until the maturity date, CDs can offer higher interest rates than traditional and even high-yield savings accounts[3]. With most CDs, these interest rates are fixed, meaning the interest rate will not change during the term of the CD.

Some banks offer "penalty-free" CDs that allow clients to withdraw money before the maturity date arrives. However, sometimes the interest rates that these CDs offer are lower than what you'd find with a traditional CD. In addition, the bank offering the penalty-free CD may require users to withdraw the entire balance at once, rather than making a partial withdrawal.

Once a CD matures, you have about a week to withdraw your funds. If you don't take your money, most banks automatically renew your CD for the same term. However, the interest rate will be based on what the bank currently offers for new CDs with that term rather than your original rate. 

It's worth noting that credit unions typically refer to CDs as "share certificates." Other than the fact that the Federal Deposit Insurance Corporation covers CDs and the National Credit Union Administration protects most share certificates, there are no fundamental differences between the two accounts[4].

What Are The Benefits Of A CD?

There are many benefits to opening a certificate of deposit account:

  • CDs are safe. Certificates of deposit are insured for up to $250,000 by the Federal Deposit Insurance Corporation. (FDIC)[5]. You can recover your deposits, up to the insured amount, even if your bank fails (an unlikely event).
  • CDs typically offer higher interest rates than traditional savings accounts. The interest rate you earn depends on the bank offering the CD and its specified term, among other factors[6].
  • Your returns are guaranteed. Unlike the stock market, CDs are predictable. When opening one of these accounts, you can determine exactly what your rate of return will be by a specified date. 
  • CDs don't charge maintenance fees. Many banks charge monthly maintenance fees for traditional savings and money market accounts. Typically, CDs require no such fees. Of course, the bank may charge a penalty if you withdraw your money before the maturity date.

What Are The Downsides Of A CD?

There are a couple of disadvantages to opening a CD account:

  • Typically, there are no penalty-free withdrawals before maturity. With most types of CDs, your money is locked in until the specified maturity date. Withdrawing funds before that date may incur a penalty, and/or you may lose any accrued interest. That makes traditional savings accounts a better place for money you may need to withdraw soon to cover a big purchase or an emergency.
  • Interest rates are fixed with most CDs. This can be both a good and a bad thing. On one hand, a fixed rate of return means your bank can't suddenly change the terms of your account. However, if the bank raises interest rates on similar CD terms after your money is locked in, you won't be able to take advantage of them. Some banks do offer "bump-up" CDs that typically allow for a one-time interest rate increase.

How Are CD Rates Determined?

Banks' interest rates on certificates of deposit are among the most important factors in choosing a CD. After all, the higher the CD rate, the more money will be in your account at the maturity date.

CD rates vary widely from bank to bank and from term to term. Rates aren't random — they're determined by a few factors:

  • The length of a CD term. Typically, the longer the CD term, the higher the interest rate.
  • The deposited amount. Many banks offer interest rate tiers based on the deposited amount. Generally, you can expect to earn higher rates for larger deposits[6]
  • The federal funds rate. The federal funds rate, which is determined by the Federal Open Market Committee (FOMC), is the rate at which banks lend and borrow money to and from each other overnight[7].

CD Tax Considerations

As with traditional savings accounts, if you have earned at least $10 in interest from a CD account during a calendar year, your bank will report it to the IRS[8].

How much taxes you owe will depend on your federal income tax rate, which currently has seven brackets from 10% to 37%[9]. Your bracket depends on the amount of your taxable income and your filing status.

In addition, depending on where you live, you may also need to pay state taxes on your CD interest. 

Typically, you must pay taxes on CD interest in the years that interest payments are posted to your account — even if the CD hasn't matured yet[10]

Your bank will report your earned interest to the federal government using IRS Form 1099-INT and will send you a copy for your records. You must report interest on your IRS tax return on Line 2 of Form 1040.

You can defer the taxes on your CD accounts by purchasing CDs in a 401(k) or IRA. Typically, the IRS doesn't tax interest earned on savings vehicles in these tax-advantaged retirement accounts until you make a withdrawal[11]

What If You Need To Withdraw Early?

If your plans change — or you have a financial emergency — you can withdraw your funds from a CD account before it reaches maturity. However, the bank will likely impose a penalty.

With many banks, before you can cash out your funds, you'll need to pay an early withdrawal penalty. This penalty varies among banks and accounts, but all terms and conditions are set out in the deposit agreement you received when you first opened the CD.

Typically, early withdrawal penalties involve losing interest money that you may have earned. For example, you may lose three months' worth of interest on CDs with terms of up to 12 months and a full year's worth on a very long-term CD. 

However, some banks charge penalties that can eat into your principal (the money you deposited when opening the CD), as well as the interest you've earned.

Alternatives To A CD

Opening a CD has plenty of benefits, but these savings accounts aren't for everyone and every situation.

Here are a few alternatives to consider:

  • Traditional savings accounts. Traditional savings accounts earn interest, although the rates are variable and may not be as high as with CDs (high-yield savings accounts tend to earn higher rates). The advantage of a savings account is that you can make as many as six withdrawals per month without penalty.
  • Money market accounts. Money market accounts also earn interest — often higher than what you'll find with a traditional savings account — and some have check-writing privileges. As with savings accounts, you may be limited to making no more than six cash withdrawals per month.
  • Bonds. Governments and corporation issue bonds to help raise money. Like CDs, many bonds pay fixed interest rates and have set maturity dates. Corporate bonds can be riskier than government bonds because companies sometimes default on their debt, leaving you without your principal. The safest bonds are those issued by the U.S. Treasury[12].