What Your Bankers Never Told You About Your Certificate of Deposits (CDs)

Question: Where else can you do business where you’re dealing with other people’s money, it’s insured by the federal government, you pay your clients as little interest as possible, and you have the potential for huge profits?

Banks, of course!

Banks love it. They love your “passport” savings, money markets, and especially Certificates of Deposits (CDs).

In the current low interest rate environment, banks get to pay you little interest on your money while they reinvest your money and stand to earn substantial profits. 

Why do you suppose banks have gigantic buildings, especially some of the tallest buildings in the world?

You guess it. They know how to make huge amounts of money on our money.

Every year, Americans pour millions of dollars into CDs with the hope to earn a few a bucks here and there. They feel safe placing their money with the banks because they see that their money is “FDIC-insured”. 

But just how safe are CDs? Let’s consider the following points:

1. Inflation Risk         The interest you earn on your CD usually does not keep up with inflation. According to Inflationdata.com, the inflation rate for July 2008 was 5.60%. And, bankrate.com showed a national average of 1-year CD rates at 3.69%. 

If you are earning 3.69% in your bank CD and inflation is at 5.60%, what is your earning?

Nothing!

When you account for taxes you have to pay for those earnings, it gets even worst!  In a 30% tax bracket, your earnings are reduced to a mere 2.58% after taxes, and -3.02% after adjusted for inflation.

At this rate, what kind of purchasing power do you have?

2. Returns       Real returns on CDs, after taxes and inflation, usually fall into negative territory about 50% of the time.  Unfortunately, a reliance on CDs to fund your retirement plan could result in big shortfalls at retirement age and may require you to go back to work.

If you’re considering long-term savings for retirement, consider using tax-deferral vehicles instead of taxable ones. As the example below shows, utilizing tax-deferral clearly provides you with an advantage over taxable savings.

This may provide you with the ability to maintain your purchasing power. And, this is one reason it’s important to find savings vehicles that not only can provide you with an inflation hedge but also tax-deferral, such as inflation-protected savings bonds, fixed rate annuities, fixed index annuities, etc.

3. Tax Risk      Not only is the earnings on a CD taxable, it could also make your Social Security income taxable up to 85%.  First, whether you are earning social security income or not, the fact that interest from bank CDs is taxable should be a concern.  You can never avoid taxes, but if you do not need the interest to supplement your income, why pay the unnecessary taxes? 

Never pay taxes if you do not have to.

Second, if you are earning social security income, then the interest you earn from bank CDs may be enough to make more of your social security income taxable.  Obviously, if you need the interest income to supplement your social security, then the extra tax burden is something you must live with.

Let’s look at an example.  If you’re a married couple earning $30,000, there are no taxes on your social security income.  However, if you earn more than $32,000 ($2,000 in additional interest from bank CDs), then 50% of your social security income becomes taxable.  If you have social security income of $24,000, then 50% of it is $12,000, taxed at 15% tax bracket and your tax obligation is $1,800. 

Basically, if you earned $2,000 more in interest, you essentially have paid nearly all of that back in taxes!

Ouch!

3. Lost Opportunity Cost       When you pay taxes on the earnings on your CDs, those tax dollars are gone forever, and you lose the future earnings potential on those dollars. You lose the opportunity to use those dollars to earn more interest in what’s called compounding interest.

But you don’t pay taxes out of your CD earnings, do you? You pay the taxes out-of-pocket. But really, is there a difference? Of course, not. A dollar out of your right pocket is no different than that which comes out of your left pocket.

Often, most bankers will tell you to let your interest accumulate or “roll over” and add to your CD’s principal. But is this good advice? 

Not only do you suffer the increasing annual tax consequences but you also lose any potential interest you could have earned on the money you paid out in taxes. This is what’s called your lost opportunity cost (taxes paid plus the interest you could have earned on that money had you not been required to pay it to the IRS).

Take a look for yourself. In this example, let’s assume you’re in a 30% tax bracket and you earn a rate of 5% on your CD. As you can see, as you continue to “roll over” your interest from one year to the next, your taxes keep rising and so does your opportunity cost!

So, after 20 years, your CD is worth $265,329.77. But you’ve paid a total of $49,598.93 in taxes and lost an opportunity to earn $75,808.51. Taking the opportunity cost away from your CD’s value, and it’s only worth $189,521.26.

3.  Liquidity Risk       There can be significant penalties to access your CD early. Most banks charge 5-15% in penalties to access your money in a CD.  You can plan around this by laddering CD maturities, but that causes two problems.  First, you can never plan well enough for emergencies and waiting for a CD to mature every year may be a problem if you need money immediately.  Second, the interest you earn when you ladder CD maturities is significantly reduced because you are committing your money to the bank for less time.  Banks do not allow any penalty-free access to your money in CDs prior to maturity.

The end result of laddering is reduced earnings and greater inflation risk and overall, bank CDs do not provide any liquidity for unexpected needs.

4. More Liquidity Risk      Banks do not allow any loans against your bank CDs.  You can certainly try to obtain a loan with your CDs as collateral, but you cannot directly access your CDs funds in the form of a loan.  This further reduces your liquidity options if you need access to your money.

5. Probate Risk      Bank CDs do not automatically avoid probate.

If you have a Will, then your entire estate will be subject to the probate process upon your death.  The probate process can cost your heirs 3-10% of your assets and take 6-12 months to full completely.  Bank CDs are not exempt from this process unless you have a Living Trust or other Trust vehicle set up to protect your estate.  The final result is that your bank CDs could be held up in the probate process and not directly accessible by your heirs.

6.  Income Risk      While it may be possible to live off on the interest on your CDs, what happens when interest rates fall like these days?

When interest earnings are not enough to supplement current income, most people begin to invade their principal, and soon all their CDs depleted.

A CD does not and cannot guarantee you a lifetime income stream.

7. Creditor Risk     Bank CDs can be garnered or seized by creditors. Having a CD in a bank is as good as cash in your pocket. You have no protection whatsoever if you are sued or if a creditor comes after you.

8. Risk of Bank Seizure        If you own a CD and take out a loan with the same bank, if you default on the loan, the bank may seize your CD. Because CDs carry no asset protection, any creditor, including the very own bank you place your CD with, may seize your CD to fulfill the obligations of your loan. 

Make no mistake about it. Your CD is not as safe as you might think.

9. Risk of Bank Failure      A Bank CD is only as safe as the Bank holding the CD. Sure, bank CDs are FDIC-insured, but when a bank fails, not everyone may get all their money back. FDIC insurance only covers up to $100,000 per depositor. If your deposits are above that, you may or may not get all of it back. Take a look at these recent bank failures. Notice the percentage of assets exceeding the insurance limit recovered.

Sources: www.fdic.gov
For the latest list of bank failures, click here. 

10. FDIC Risk           If you think your CD or money at the bank is safe because it’s FDIC-insured, you may wish to think again. First, the FDIC is an insurance corporation; FDIC stands for “Federal Deposit Insurance Corporation.

The FDIC was created by the federal government in response to the many bank failures in the 1920s and 30s. It’s goal, to restore consumer confidence in the national banking. Just like it says in it’s name, the FDIC insures deposits in accredited banks and thrifts up to $100,000.

Since the creation of the FDIC, no one has ever lost any insured money after a bank failure.

However, there are many instances where people have lost money, and it’s important that you do not. Here are some situations you may want to pay particular attention to:

A.     PAYABLE-ON-DEATH  (POD) ACCOUNTS        Each beneficiary’s share of a POD account may be insured up to $100,000 ($200,000 if there are two beneficiaries, $300,000 if there are three, and so on). However, the beneficiary must be a “qualifying” beneficiary. That is, the beneficiary must be the grantor/depositor’s spouse, child, grandchild, parent or sibling. Other relatives, such as nieces, nephews, cousins or in-laws, as well as friends, do not qualify the account for the additional insurance coverage provided to other POD accounts. What happens if you name a non-qualifying beneficiary? The portion payable to that person would be added to any accounts you have at the bank in the single (or individual) account category and the total will be insured to $100,000.

Example: You have a $300,000 CD at the bank with POD designation, with your nieces and nephews as beneficiaries. Because they are not considered “qualifying” beneficiaries, if your bank fails, you are only insured up to $100,000, the rest is not insured.

B.    LIVING TRUST AS BENEFICIARY          You set up a living trust as a way to retain full control over your assets from the grave. However, you may be surprise to find out some of your kids’ inheritances may go up in smoke if the bank holding your CD or other funds fail. 

FDIC rules treat a living trust similar to that of a POD account. As such the rules require that the funds be passed directly to the named beneficiaries without any condition. 

However, most living trusts do contain provisions and conditions before any payment is made to your kids, such as a child must not get married before his/her 30^th birthday, or he/she must graduate from college, etc.

As a result, living trust accounts very often are ineligible for the $100,000-per-beneficiary insurance coverage. Instead, they likely would be insured to $100,000 in total along with any individually-owned deposits of the person who established the living trust account.

C.    IRA ACCOUNTS & KEOGHS        If you purchase a CD within your IRA or Keogh Plan, generally speaking, you are insured separately from your other account types, up to the maximum limit of $250,000.

However, if you have an IRA worth more than $250,000 and you spread it among different branches of the same bank, and named different beneficiaries, all your accounts must be added together and you can only be insured up to an aggregate of $250,000. 

So, say for example, you have $500,000 in CD IRAs, and you split them into 5 different $100,000 IRA accounts at 5 different branches of the same bank. You’re still insured only up to $250,000; the rest of the $250,000 is not insured.

D.    JOINT ACCOUNTS    If you have a joint account with a spouse, child or another person, FDIC rules state that you can not be insured for more than $100,000 for your share of all joint accounts.

Example: You own a joint CD account with your spouse for$200,000. FDIC rules state that you would be insured for $100,000 and your spouse $100,000. 

However, if you have $500,000 worth of CDs and you have more than one joint account at the same bank, the rules say you cannot be insured for more than $100,000 for your share of all those joint accounts, $400,000 would be uninsured.

E.     MULTIPLE BANK CDs       If you have more than one CD at a bank and all total more than $100,000, you are only insured up to $100,000, the rest is not insured.

Example: You bought a CD October 1^st of last year for $50,000. Then a broker sold you another CD with the same bank (but you were not aware of it) for another $75,000. You’re only insured up to $100,000, the $25,000 above the limit is not insured. 

For additional on FDIC coverage, visit the FDIC website.

When was the last time your bank told you these potential risks with your CD or bank deposits?

For a complimentary review of your CDs and bank deposits so you may avoid these common risks and more, click here and an Advisor will contact you promptly.