Bonds vs. CDs for Long-Term Savings


If you're looking to save money for the long term, two of the safer options you can choose are bonds and certificates of deposit. Both generally pay money at a steady rate of interest for a fixed period of time. Some government bonds also have income tax advantages, and CDs generally are insured by the federal government. Whether you choose a CD or bond, neither typically delivers the risk or potential reward of investing in the stock market.

Investing in Bonds

Bonds are a type of investment vehicle that you can buy and sell through a brokerage on an open market, similar to stocks. Unlike stocks, which represent a stake of ownership in a company, bonds represent an interest in a debt. Some bonds are issued by private companies, and some are issued by government agencies.

A bond's initial interest rate at the time it's issued is called its coupon rate. That term comes from when bonds were issued with paper coupons that bondholders could clip with scissors and mail in to receive interest payments. Since bonds can be resold for prices above or below their original prices, the effective interest rate that buyers can receive can vary with that purchase price. That rate is known as a bond's yield.

How bond interest is taxed when you pay income tax can vary. Interest on corporate bonds is typically taxed at the same rates as ordinary income, such as income from working a job. Interest on federally issued bonds is typically exempt from federal income tax. Bonds issued by state or local governments, known as municipal bonds, are often exempt from both federal income tax and state and local income tax in the state where they're issued.

Exploring Bonds and Risk

Different bonds carry different yields and other terms, such as how long they pay out. Bonds also vary in risk, since different organizations that issue them have different likelihoods of defaulting, or stopping payment. Because of laws governing how creditors are paid, bondholders are often more likely to recover some of their investments when a company goes bankrupt.

Bonds carrying higher risk generally have higher yields. You can find publicly available information about the credit ratings of bonds, generally given as letter grades, and the companies that issue them. Particularly high-risk bonds, with the potential for particularly high rewards, are sometimes known as junk bonds.

If you choose to invest in bonds, choose bonds delivering yields and tax consequences you want with a level of risk you're comfortable with.

Understanding Certificates of Deposit

Certificates of deposit are a special kind of account you can open with a bank or a credit union. They generally pay a higher interest rate than traditional savings or checking accounts in exchange for requiring you to agree to keep your money in the account for a specific amount of time. If you remove the money earlier, you may face a penalty depending on the account terms.

Different CDs, as they're commonly called, have different rates and different maturity times. They also have different penalties for early withdrawals, and some have special provisions where you can elect to change the account interest rate or contribute additional funds after it's been open for a certain amount of time.

You can open a CD with most banks and credit unions in the United States. Generally, bank deposits are insured up to $250,000 per depositor per bank by the Federal Deposit Insurance Corporation. Credit union deposits are similarly insured by the National Credit Union Administration. Bank interest is taxed as ordinary income in the year you receive it.

Brokered Certificates of Deposit

Some financial institutions, typically brokerages, offer what are called brokered certificates of deposit. They usually place your funds with partner banks looking to raise deposits and can automatically distribute your money across multiple institutions to avoid exceeding the FDIC insurance limits.

They will generally deliver the same interest rates no matter which institution your money is actually placed in so you can search for, say, Fidelity CD rates or Merrill Lynch CD rates, without having to worry about which banks the money will end up in. Check with your brokerage or research brokerages online to see what your options may be.

Investing in CD or Bonds?

CDs and bonds can have fairly similar investment profiles. Both offer interest rates that fluctuate with prevailing rates and generally low risk of losing your money.

Technically, insured bank deposits are usually considered safer than bonds, but it's possible to find government-issued bonds that are quite safe as well. It's usually possible to find riskier bonds that pay higher rates of return than you could find from CDs or other standard bank products, but these do bring higher risk.

You can also include both in your investment portfolio. Consider what mix of risk and reward makes sense for you given your long-term investment goals.

Considering Investing in Stocks

It can also be useful to include some stocks in your investment portfolio. These are generally riskier than bonds or bank accounts, since you can lose much or all of your money if you invest in a company that goes bankrupt or otherwise struggles.

On the other hand, good stock investments can grow more dramatically than bond investments, delivering you a high return, especially in the long run. If you're investing long term, stocks can also be a good investment since you can effectively wait out any downturns in the market.

Investing in Funds

Another alternative to a CD or bonds is to invest in mutual funds or index funds.

Mutual funds are generally actively managed funds, meaning that trained experts pick investment opportunities like stocks or bonds in which your money is placed in exchange for a fee. Some invest specifically in stocks, bonds or other types of investment vehicles, while some invest in a mix. You can invest in mutual funds through the companies that manage them or, often, through brokerages.

Index funds generally invest money according to a published rule, such as automatically buying the stocks in a particular stock market index, like the S&P 500 or the Nasdaq Composite. Some invest in broad groups of bonds as well. They carry lower fees in most cases than actively managed mutual funds.

Many modern funds are exchange-traded funds, meaning that you can buy them through any broker in a process similar to buying stocks.

Using Tax-Deferred Retirement Accounts

You can put money into a CD or bonds, as well as alternatives like stocks and funds, through a traditional individual retirement account, or IRA. This is a special type of investment account that lets you deduct the money that you put into it each year from your taxable income, up to an annual limit published by the Internal Revenue Service.

When you withdraw money from an IRA after retirement age, you pay tax on the money you withdraw. If you withdraw money early, you must pay the deferred tax and, often, an additional penalty tax. An IRA can be a good choice for long-term investments since it lets you defer your taxes into old age.

If you have a 401(k) or 403(b) account at work, it operates in a similar way, although your investment choices may be more limited.

Another type of IRA, called a Roth IRA, has you taxed as usual on money you put into the account. The money in the account, however, grows without additional taxation and you can withdraw the funds, including your earnings, at retirement age without additional tax. It's another good option for long-term investments.

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