Certificates of deposit (CDs) have long been a safe, reliable option for getting stable, fixed returns. One common strategy for using CDs is to create a “CD ladder” with staggered maturity dates. This process involves reinvesting the proceeds of one CD as it matures into the next one, and so on. Here is some helpful information about CD ladders, including how to make one, the optimal length, pros and cons, and tax considerations.

What Is A CD Ladder?

Certificates of deposit (CDs) are financial products offered by banks and credit unions with fixed interest rates and terms. For example, you can purchase a CD offering 5% interest with a 1 year term.

A CD ladder is a structured investment approach that involves dividing a sum of money into equal parts and investing each part into CDs with varying maturity dates. By staggering the maturity dates of CDs in a ladder, investors can achieve a balance between liquidity and higher interest rates.

What Is The Best Way To Build A CD Ladder?

The best way to build a CD ladder is to start by determining your financial goals and the amount of money you want to invest. Once you have this information, follow these steps:

• Assess Your Financial Goals: Determine the purpose of your CD ladder. Are you saving for a specific future expense, such as a major purchase or retirement income?
• Divide Your Investment: Divide your investment amount into equal portions. For example, if you have $10,000 to invest and decide on a 5-rung CD ladder, each rung would be $2,000.
• Choose CD Terms: Invest each portion in CDs with different maturity dates. For a ladder, you might choose CDs with terms ranging from 1 year to 5 years, depending on your risk tolerance and liquidity needs. So you would open five CDs like this:
  • $2,000 into a 1 year CD
  • $2,000 into a 2 year CD
  • $2,000 into a 3 year CD
  • $2,000 into a 4 year CD
  • $2,000 into a 5 year CD
• Reinvest as CDs Mature: As each CD matures, reinvest the proceeds into a new CD with the longest term in your ladder. This process continues, creating a cycle of maturing CDs that you can either reinvest or use as needed.

Alternate CD Ladder Setups

Aside from the traditional CD ladder structure, there are some other options to match your goals:

• Mini CD ladder: If you don’t want to tie up your money for too long, consider a mini CD ladder. This setup includes shorter-term CDs, like six, nine, twelve, and eighteen months.
• Barbell CD ladder: Imagine a traditional CD ladder, but skip the middle rungs. One side is stacked with short-term CDs, while the other side has longer-term ones. It lets you access some cash sooner while enjoying higher rates on the longer terms.
• Bullet CD ladder: This strategy involves opening CDs at different times with various term lengths, all set to mature together. For example, grab a five-year CD now, a four-year one in a year, and a three-year one in two years. It’s handy for planning big expenses since you don’t need all the cash upfront, giving you time to add more CDs as you save.

Are CD Ladders Good For Retirees?

CD ladders can be a reliable option for retirees seeking stability and steady income. However, creating a CD ladder also comes with some disadvantages that investors should consider before implementing this strategy. Here are some pros and cons to think about when setting up a CD ladder.

Pros of a CD Ladder:

• Stability: CDs are generally considered low-risk investments, providing a stable source of income and preserving capital.
• Predictable Returns: CDs offer fixed interest rates, providing investors with predictable returns over the investment period.
• Liquidity: A CD ladder provides regular access to funds as CDs mature, offering liquidity without penalties associated with early withdrawal.
• Diversification: By investing in CDs with different maturity dates, investors can spread risk and potentially benefit from varying interest rate environments.
• FDIC Insurance: CDs offered by banks are typically FDIC-insured up to the maximum allowed by law, providing additional security for investors.

Cons of a CD Ladder:

• Lower Returns: Compared to riskier investments such as stocks or mutual funds, CDs generally offer lower returns, especially in low-interest rate environments.
• Limited Flexibility: Once funds are invested in a CD, they are locked in until maturity, limiting flexibility for reallocating investments or taking advantage of market opportunities.
• Interest Rate Risk: If interest rates rise after investing in long-term CDs, investors may miss out on potentially higher returns available in the market.
• Inflation Risk: CDs may not keep pace with inflation, potentially eroding purchasing power over time, especially with low interest rates.
• Early Withdrawal Penalties: While CD ladders offer liquidity, early withdrawals from CDs before maturity can result in penalties, reducing overall returns.

How Are CD Ladders Taxed?

CDs are typically taxed as interest income in the year they mature or are redeemed. This means that the interest earned on CDs is subject to federal income tax and, depending on your state, may also be subject to state income tax. It’s essential to factor in tax implications when planning your CD ladder to ensure accurate projections of after-tax returns.

Building a CD ladder can be a prudent strategy for retirees and investors looking for stability, predictable returns, and liquidity. By following best practices, understanding the ideal ladder length, and considering tax implications, you can create a financial structure that supports your long-term goals and retirement income needs.