The Popularity of CDs and Alternative Investment Options
CDs have surged in popularity, but are there better investment options? Explore insights from an investment expert and learn about tax advantages, use cases, and recommendations for wealthy clients.
Troy D. Hanson
September 08, 2023
CDs have experienced a surge in popularity as interest rates have been on the rise since March 2022. According to data from the Federal Reserve, CD balances have increased by a staggering $400 billion, from $36.5 billion in April 2022 to $418.4 billion in January 2023.
The appeal of CDs is evident, with some institutions offering attractive Annual Percentage Yields (APYs) of around 5% (check out the highest CD rates available here).
A Shift in Perspective: Insights from an Investment Expert
To gain further insights on this trend, we spoke with Carl Ludwigson, a managing director at Bel Air Investment Advisors. Ludwigson oversees and manages assets totaling a reported $9.5 billion for high-net-worth families, foundations, and endowments. His vast experience in portfolio construction and client service spans over a decade, including notable positions at Credit Suisse and Merrill Lynch.
However, despite his expertise, Ludwigson does not recommend investing in CDs to his wealthy clients at present. Instead, he suggests exploring alternative options that can take advantage of high short-term interest rates, such as Treasury bills and short-term municipal bonds.
Bonds Offer Tax Advantages
Ludwigson's preference for bonds over CDs is partly due to the better tax perks they provide. He highlights that short-term municipal bonds could be federal and state tax-free, ultimately leading to a more favorable tax-adjusted return.
It's important to note that interest income from CDs is subject to taxation at your highest marginal federal income tax bracket and state level in most states. Your certified financial planner can provide you with further guidance on CD taxation, but it's worth considering tax brackets, which range from 10% to 37%. The higher your tax bracket, the less interest you keep, as confirmed by certified financial planner John Piershale at John Piershale Wealth Management.
Assessing the Use Case for CDs
Ludwigson acknowledges that there may be specific individuals who find CDs useful, particularly those investing below the FDIC-insured amount and willing to lock up their capital for a defined period. However, he reminds investors that CDs come with penalties for early withdrawal. While some CDs offer a slight illiquidity premium compared to short-term treasuries, it's crucial to consider that treasuries are state tax-exempt and highly liquid.
In summary, while CDs have gained popularity due to rising interest rates, it's essential to weigh other investment options. By exploring Treasury bills and short-term municipal bonds, investors may find opportunities that align better with their financial goals and tax considerations.
Do Financial Planners Recommend CDs for Wealthy Clients?
In the world of financial planning, the question arises: do financial planners typically recommend Certificates of Deposit (CDs) to their affluent clients? The answer is not a simple yes or no. Although CDs are considered low-risk investments, they also offer low returns. Therefore, financial planners weigh various factors before making a recommendation.
Blaine Thiederman, a certified financial planner, points out that high-net-worth individuals usually have diversified portfolios already. According to the Federal Reserve, as of August 2023, the average interest rate for a 1-year CD is just 0.22%. In comparison to potential returns from equities or bonds, this seems like a meager amount. Thiederman advises against CDs when clients are seeking growth. Historical data reveals that the S&P 500 has provided an average annual return of 10% to 12% over the past 90 years, while bonds have averaged over 5%.
Bri Conn, an investment adviser representative at Childfree Wealth, acknowledges that CDs can be useful for people with a significant sum of money earmarked for a specific future purpose. However, she cautions against assuming CDs are always the best option. One disadvantage of CDs is that the funds must remain untouched until maturity. Additionally, given the current high-yield savings account interest rates, Conn does not generally recommend CDs to most clients, regardless of their wealth.
In cases where the preservation of principal is paramount, wealthy individuals can benefit from investing in CDs. David Piershale suggests that buying CDs within an Individual Retirement Account (IRA) can be particularly advantageous. IRAs enjoy tax advantages, allowing for tax deferral on CD earnings until distributions are taken or generating tax-free income in qualified distribution cases within a Roth IRA.
Overall, financial planners take into account multiple factors, such as risk tolerance, investment goals, and prevailing interest rates, when determining whether to recommend CDs to their wealthy clients. While CDs may not always be the optimal choice for growth-oriented investors, they can serve a purpose in specific situations, especially when combined with tax-favored accounts like IRAs.