Inflation is a huge fear among investors, so the notion of a special CD that hedges against inflation is a no-brainer, right? Maybe, and maybe not.
Market index CDs do have their good points, including a guaranteed protection on your original investment, and they’re also FDIC-guaranteed up to $250,000. But the downside may not be worth the trouble.
Here’s the deal.
Market index CDs are certificates of deposit that pay interest that is linked to the performance of an underlying index, like the U.S. stock market. Ostensibly, banks tout index CDs as offering stock market returns but with the safety and protection of traditional CDs. That paints a compelling picture: an investment where no principal can be lost, but which could pay out big based upon the performance of a given stock market index.
Investors looking for some extra shelter against plummeting investment portfolios would likely see index CDs as a good fit. And they wouldn’t be alone. According to Arete Consulting, market index CD sales rose 46% through the first five months of 2009 to $1.66 billion.
With CD yields at near historic laws, index CDs would seem to have significant appeal. But not so fast. Let’s look at some possible “issues” surrounding these unique bank products.
Absolute barriers – Market index CDs have caps that can negate any gains you might have made on your investment. These “absolute barriers” establish performance parameters where, if reached, eliminate all of your investment returns. For example, if your index’s barrier is 15% and it shoots beyond 15% either on the high or low end, performance-wise, you lose your earnings (but not your principal).
Early withdrawal penalties – One mistake that casual investors might make is to assume that, like a regular CD, you can withdraw money early. Sure, you can do that – but expect to lose not only your earnings, but some of the principal you’ve poured into the CD as well.
Taxes – If you’re not careful, and don’t buy your market index CD within a tax-advantaged vehicle like an individual retirement account, you could pay through the nose to the IRS. How so? Because market index CDs held in a taxable account can generate taxes on earnings from your investment.
The consensus? If you commit to a five-year market index CD, and leave the money alone, you may actually get the best of both worlds: access to stock market gains with protection against any loss of interest.
But one false move, or even one wild swing in the market that triggers a barrier cap penalty, and you could be out of luck. And out of the money.
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