IRA vs. CD: What’s the difference?

What is an individual retirement account (IRA)?

An IRA is a savings plan that provides tax advantages on the funds you contribute to the account. If you open a traditional IRA, your contributions may be tax deductible, which can be a helpful strategy for some taxpayers. You can open IRAs with banks, other financial institutions and professionals like stockbrokers and life insurance companies.

However, IRAs have limits to how much you can contribute per year. For 2023, the IRA contribution limits are $7,500 if you’re 50 or older and $6,500 if you’re younger than 50. These limits apply to the aggregate contributions you make to all of your IRAs, meaning you can’t get around the limits by opening another IRA.

There are two primary types of IRAs:

• Traditional IRAs: You can contribute to this type of IRA if you or your spouse earn taxable income. Your contributions may be tax deductible, and the amount you contribute to your IRA each year can’t exceed the IRS’s annual contribution limits.
• Roth IRAs: Besides needing to earn taxable income, you can contribute to a Roth IRA if you have a modified adjusted gross income (AGI) below specific thresholds. For example, in 2023, you can make contributions up to the limit if you’re married filing jointly and your modified AGI is less than $218,000.

You may be required to pay additional taxes if you withdraw funds from your IRA and are under 59 ½ years old. Once you reach age 72, you must begin taking distributions from a traditional IRA; you keep your money in it perpetually.

Another key feature of IRAs is that they belong solely to you. This differs from an employer-driven retirement account, like a 401(k), where you’re a participant and can only contribute to the account as long as the company still employs you. With an IRA, you are the account owner and can contribute to it no matter where you work.

If you need to access your funds before age 59 ½, want to save more money than the annual contribution limits and want to be able to access your funds easily without paying additional taxes before retirement, you might want to consider a different savings account, like a CD.

» MORE: How much do I need to retire?

Pros and cons of IRAs

Some of the best things about IRAs are the potential tax advantages, such as deductions, credits and deferrals. Plus, IRAs are easy to set up with most banks and brokerages, and you can keep contributing to them even if you change jobs.

However, some of the key drawbacks to an IRA are that your annual contributions are limited by the IRS, you have to pay additional taxes if you withdraw funds early, and you must start taking distributions from traditional IRAs once you reach 72 years of age.

The pros and cons of IRAs are:

What is a certificate of deposit (CD)?

A CD is a savings account where you make a single deposit into the account and earn a fixed interest rate for a set period (term). CD terms commonly range from as short as one month to as long as five years. Generally, the longer the term, the higher the annual percentage yield (APY) you’ll earn.

The returns you earn on traditional CDs aren’t tied to an index, like the stock market. Rather, the interest rate is guaranteed for the entire term of the CD, making it a predictable and relatively safe investment. Plus, CDs held at Federal Deposit Insurance Corporation-insured banks are backed by government deposit insurance, adding another layer of safety.

Many banks charge an early withdrawal penalty if you need to pull funds from your CD before the term ends. Although penalty amounts vary, they usually equal a fraction of the interest you would have earned over the remaining term.

CDs typically earn higher interest rates than other savings accounts, since you promise the bank you’ll keep the money on deposit for the specified term. For this reason, CDs are a good savings option if you don’t think you’ll need to access the funds until the term expires. However, you’ll usually pay taxes on your interest earnings at your ordinary tax rate.

» MORE: CDs vs. savings accounts: Which is right for you?

Pros and cons of CDs

One of the greatest benefits of a traditional CD is that it’s relatively low-risk. Plus, it’s quick and simple to open at most banks. Furthermore, it’s easy to predict your earnings, since the rate is fixed. However, you usually can’t add funds after the CD is opened, will pay a penalty to access your funds early and have to pay income taxes on your interest earnings.

The pros and cons of CDs are:

What is an IRA CD?

You can put many financial instruments or investments in an IRA, including CDs. Mark Hayes, a certified financial planner and the founder of Infinitive Wealth Advisory, explained: “The IRA is a type of account, while the CD is a financial instrument. Metaphorically, you could think of the IRA like a box and the CD is something that you could place inside that box.”

For those who are risk-averse, CDs are a great way to earn a fixed rate of interest. Plus, CDs with FDIC insurance are backed by a government guarantee, adding to their safety.

Myers said: “If you buy a CD inside an IRA, you won’t pay taxes each year. Instead, by staying under the umbrella of the IRA, you’ll continue to grow the value of your CD tax-deferred, or tax-free in the case of a Roth IRA.”

Should you open an IRA or CD?

IRAs are a good option for saving for retirement. CDs are a good option if you want to access your funds before you retire, don’t plan to access the funds in the near term and want to earn a fixed rate of interest on the money you invest. Plus, CDs are considered a safe investment because they carry deposit insurance when held at an FDIC-insured bank.

Some key factors you should consider when choosing between an IRA and a CD are:

• When you plan to access the funds: You can’t access IRA funds without paying additional taxes until you’re 59 ½ years old. A CD is a better option if you think you’ll need to access the funds before retirement age.
• Tax implications: The primary benefit to IRAs is the associated tax benefits. If you want to gain additional tax deductions or defer some of your taxes, an IRA may help you achieve these goals. You’ll need to pay taxes on interest earnings with a CD.
• Contribution limits: You can put as much money as you want into a CD. By contrast, the IRS limits the annual contributions you can make to a traditional IRA. In 2023, these limits are $6,500 if you’re younger than 50 and $7,500 if you’re 50 or older.
• Average returns: IRAs generally earn more money than CDs because the funds are invested in them for longer. Plus, you can add most investment types in an IRA, which can increase the average returns.

Bottom line

IRAs and CDs allow you to set aside money for the future and earn a higher rate of return than with a traditional savings account. IRAs are intended for retirement savings, whereas CDs can be used to save money for virtually any purpose.

Whether you choose an IRA or a CD, you won’t be able to easily access the funds without paying some kind of penalty. You may need to pay additional taxes to access your IRA before retirement, and most CDs charge an early withdrawal penalty if you access your funds before they mature.

Before placing your funds in an IRA or CD, carefully evaluate your financial goals and the features of each type of account to choose the one that’s right for your needs.