THE STEADY STAPLES OF A WELL-BALANCED PORTFOLIO
ever long you invest your money. Generally, the longer your money is in a CD, the better an interest rate you will receive. You may also be able to purchase CDs that have variable interest rates. Since your money will be tied up for a specified time period, there may be a sur- render charge for redeeming the CD early.
Banks, credit unions, and savings and loan institutions aren’t the only place to purchase CDs. This will help if you decide you want to invest in one because you can shop around for the best interest rate. Many stock brokerage houses sell CDs that were issued by banks or credit unions. Through brokered CDs, you may have access to a sec- ondary market for your CD, which could negate the possible surren- der charge. They may also offer slightly higher interest rates.
Because you lock in your interest rate when you initially invest your money in a CD, you may be subject to interest rate risk. When the interest rate begins to rise, the corresponding rates on CDs will also rise. By locking in your rate earlier, you will be earning less than if you were earning the current rate. Plus, you wouldn’t be able to pull your money out to reinvest at a higher rate without incurring some type of early withdrawal penalty. Interest paid on CDs is fully taxable for federal and state income taxes. However, the surrender penalty may be deductible from your gross income for tax purposes.
There are also market-linked CDs, which are tied to an equity index, like the S&P 500 stock index. These CDs have an FDIC- guaranteed principal, but their return is based on the market’s actions, provided that the investor has held the CD until maturity. For example, if you purchased a market-linked CD (MLD) for $5000 and the applicable market index increased, at maturity you would receive your principal of $5000 plus a return based on the index’s appreciation. However, should the market go down, you wouldn’t receive any return on your money. You would simply receive your original investment of $5000 back. If you were to redeem or sell the MLD prior to maturity, chances are you wouldn’t receive 100 percent of your principal.
For tax purposes, the gain on the investment is taxed annually as ordinary income even though the investor sees no current interest income from the MLD. This is why MLDs are usually held in tax- qualified plans.