The Truth About FDIC and Certificates of Deposit (CDs)

When you are told by a banker or receive a promotional letter from a financial institution regarding a special Certificate of Deposit (CD) rate, please think before you act. Most bankers love CD’s simply because it will lock your money into a product that will charge a substantial fee if withdrawn prior to maturity. In addition most bankers get a commission for new money deposited into a CD. When I was a banker, I had always been one of the few that disliked CD’s for many reasons. I find them only useful for very few things. Since I am no longer a banker I want to give you the dirty truth behind CD’s that most do not know and what is your REAL rate of return from those “promotional” CD’s you find online or in your current bank.

First off, CD’s are a fixed income vehicle that is backed by the FDIC. Many people trust the FDIC for its insurance and the deposit is in fact guaranteed (up to $250,000 per DEPOSITOR until 12/31/2013). What you most likely did not know is how you get paid and when. You are covered up to this a certain amount but the time it takes to pay you however is never documented. From my research and what I was taught years ago as a banker is the following: The FDIC can take up to 99 years to pay (not a typo)! There is no public documentation of how long it takes to pay however based on the fact that if ANYTHING catastrophic was to occur financially, the FDIC will have time to pay. So if you expect immediate payment with a simple claim of lost funds from an FDIC insured product, you are sadly mistaken. The FDIC is also an INDEPENDENT AGENCY of the federal government. They receive no congressional appropriations (money) and it’s fully funded by the premiums (payments) from banks and thrift institutions pay per deposit coverage as well as earnings from U.S. Treasuries. Most people do not have to worry however since most major banks are more than willing to buyout smaller/failing financial institutions in order to acquire more clients and show positive PR (public relations) to the masses. This has shown more than enough evidence with what has happened in 2008-2009.

FDIC products are fully taxed. If you purchase a CD, the growth will be fully taxes (state, federal, local) just as if you have earned this income from working. This is based on your tax bracket which is as follows (2010):

Bracket / Single / Married:
10% Bracket / $0 – $8,375 / $0 – $16,750
15% Bracket / $8,375 – $34,000 / $16,750 – $68,000
25% Bracket / $34,000 – $82,400 / $68,000 – $137,300
28% Bracket / $82,400 – $171,850 / $137,300 – $209,250
33% Bracket / $171,850 – $373,650 / $209,250 – $373,650
35% Bracket / $373,650+ / $373,650+

Now, most of you that purchase CD’s are aware of this. However, what most fail to realize that CD’s do NOT catch up with the rate of inflation. The rate of inflation is measured by the CPI (Consumer Price Index, I have described what this details on a previous article which can be found in my previous post). For whatever investment, income, or interest you earn to not match or exceed the CPI, you are losing money long term. This is a volatile index but long term averages around 2.5%. This means you must earn either 2.5% or more AFTER TAXES long term in order to maintain your cost of living life style.

For example: You are in a 25% bracket and have purchased a 12 month CD at 2% APY for $50,000. You earned $1,010 from the interest which equals 51,010 but you have to pay taxes on the growth (your tax bracket) which will equal to $253. You have earned after FEDERAL taxes $757 (some state and local taxes may occur that will lower your return even further!). Now here is where most people do not pay attention to, the CPI for the year. Let’s be fair and say it is 1.6% for the year (less than the average, just to make a point). You would need to earn $800 AFTER TAXES from that 50,000 in order to keep up with the rate of inflation. Your real rate of return is negative $43. In order to keep up with this rate of inflation you would need to find a CD with the rate of (approximately) 2.8% or higher depending on what state you live in. Please remember that we are talking about a tax payer in the 25% bracket which is considered the national average. These rates become considerably higher if you’re considered “High-Net-Worth”.

Not all CD’s are bad. If you are one of many that cannot withstand volatility what-so-ever than it is best to purchase CD’s within a IRA this way taxes are deferred or Roth IRA which no taxes are paid after withdrawal (please see my article on IRA’s for details). Also, CD’s are probably the best product to purchase if you are planning on using the money short-term and cannot risk ANY volatility. Short-term can be considered 2 years or less. I highly recommend CD’s for home buyers (in 2 years or less) since the deposit in your home are tax deductable therefore the taxes on interests earned on a CD will be taken care of.

There are many considerably safe products that have low maturity dates and have considerably better returns than a CD. In the end, before you purchase the CD, know what your intentions are and when do you think you’re going to need it. If it’s for educational purposes, there are products that can be a better option for you and your child (529 plans, UGMA/UTMA for example). If it’s for medical bills, there are products out there for that as well (Health saving plans). The point is to use a CD only for short term purchases that can be tax deductable or within tax favor accounts. Many people use CDs to prepare for a birthday or holiday in that year and that is OK as well! The key is “short-term”. If it is for emergency funds, your best bet is to simply put it in a money market where there won’t be any implications or charges for early withdrawal.

I hope I was able to educate you on CDs and now more aware of what you are getting into. If you have any questions or concerns please feel free to contact me!

Resources:
FDIC: http://www.fdic.gov/about/learn/symbol/index.html
SIFMA Calculators: http://www.investinginbonds.com/story.asp?id=207