Roth IRA CD Laddering

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This article is by staff writer Kevin Mulligan. Kevin is developing a personal finance freelance writing career.

Our last post showed off how you can use a certificate of deposit inside your Roth IRA if you aren’t keen on investing in the stock or bond markets. Maybe you’re afraid of an up and down market, or maybe you’re at a stage of life where you would rather preserve capital and earn a bit of interest.

Setting up a certificate of deposit is the first step. Pick how long you want to lock up your funds, look at the interest rate, and make a decision to deposit your funds or not.

But that’s just the first step. If you put all your funds into one giant CD then you’re putting yourself at a few risks and missing some potential reward. Let me show you how.

The Risk of a Giant Certificate of Deposit

You’ve made a decision to put 25% of your portfolio in a CD. You look through the interest rate options and select a 5 year certificate of deposit with an interest rate of 2.60%.

That’s all well and good. You’ve made a decision. You aren’t procrastinating.

But you’ve taken on two pretty big risks to get that CD set up.

1. You’ve locked up all of your funds for the entire five year period. If for whatever reason a situation came up where you needed to access those funds you would likely end up paying a penalty to withdraw from the CD before it matures.
2. You’ve locked in a low interest rate. Sure 2.60% seems like a great rate today when interest rates are running about 1% for online saving accounts. But what happens when inflation starts to kick in or the Federal Reserve starts raising core interest rates?

Use a CD Ladder in Your Roth IRA

To combat these two risks you should use a CD ladder if you elect to use CDs in your Roth IRA.

What is a CD Ladder?

A CD ladder is a set of certificates of deposit with varying degrees of maturity. Instead of investing all of your funds into one giant CD you spread them out over several CDs that mature at different dates.

Why Use a CD Ladder?

A CD ladder avoids the risks mentioned above. You spread out your funds across multiple interest rates and time periods. I’ll use an example below to show how this improves liquidity and eventually improves your interest rates.

How to Set Up a CD Ladder

Let’s say you’ve got $30,000 you want to put into CDs. Instead of taking that 5 year 2.60% CD you decide to split the money up into a 12 month, 24 month, and 36 month CD.

These are the rates you find:

• 12 month: 1.35%
• 24 month: 1.65%
• 36 month: 1.90%

You’ll note those rates are lower, but that’s okay. When you set up a CD ladder you’re anticipating lower rates in the short term. You are trading a slight bit of rate for increased liquidity and flexibility if rates change drastically. Instead of having to do without your funds for a full 3 or 5 years you’ll get access to 33% of them every year.

Hopefully you won’t need those funds. And if you don’t you just roll the maturing 12 month CD funds into a new a new 3 year (36 month) CD. If rates have gone up due to inflation you’ll get the higher rate rather than being stuck for 5 years with a lower fixed rate.

As time goes on you simply keep building on the ladder. Every year when a CD matures you invest into a new 3 year CD.

And the time frame doesn’t have to be three years. You could pick 5 years if your financial institution also offered a 1, 2, 3, and 4 year certificate of deposit. However high you want the rungs on your CD ladder to be is up to you.