IRA vs CD — what's the difference and which one should you pick?

Choosing between a certificate of deposit (CD) and an individual retirement account (IRA) boils down to your plans for the money. CDs offer stability for short-term goals with fixed APYs while IRAs allow you to invest in the stock market for long-term retirement savings. Learn how to use both account types to meet your financial goals.

A certificate of deposit is an interest-bearing account offered by banks and credit unions where you place your money. Unlike savings accounts, most CDs require you to lock away your funds for a certain period (called the CD's term). Because of that, the APY of your CD typically won't change during the CD's term, no matter what happens with interest rates in the wider market. When interest rates are high (and you expect they may fall soon), it can be a good idea to put some money in a CD to lock in those high rates.

Alliant Credit Union, our top pick for CD rates, offers CDs with up to 5.20% APY with terms ranging from three months to 60 months with a minimum $1,000 deposit required.

Aside from traditional CDs, there are alternative options such as the bump-up CD, which lets you request a higher APY if rates increase mid-term, or the no-penalty CD, which allows you to withdraw your money before the term ends without paying a fee. Ally Bank offers several of these types of CDs at competitive rates and with terms ranging from three months to five years. The five-year Ally Bank High Yield CD, for example, offers a 3.90% APY for no minimum deposit required.

Alliant also offers jumbo CDs where you can earn higher rates with deposits of $75,000 or more.

While CDs help set aside your funds for a certain period, they do come with some caveats that are important to consider.

Pros

• Guaranteed rate of return - With CDs, you agree to deposit your funds for a set duration at a fixed interest rate, ensuring a consistent return on your investment.
• Higher yield than savings accounts - CDs typically offer a higher yield than savings accounts, including some high-yield savings accounts, since you have far less flexibility of when to withdraw your money.

Cons

• No liquidity - You won't be able to access your CD's money before the end of the term without penalty.
• Early withdrawal penalty - Penalty fees associated with CDs can vary depending on your bank and your CD's term length, but they're usually based on the interest earned or the interest you would have earned over a certain number of days or months.

An IRA is a tax-advantaged investment account that individuals with taxable income can set up through a financial institution. IRAs are like 401(k) plans in that you can invest money into different assets such as stocks, bonds or mutual funds but unlike most 401(k)s, IRAs can be opened by an individual instead of an employer.

Traditional IRAs allow for pre-tax contributions, meaning you generally won't pay any taxes on your contributions until withdrawal in retirement. Roth IRAs involve contributing after-tax dollars, allowing you to make tax-free withdrawals later in life.

IRAs also come with annual contribution limits and you must typically wait until age 59 ½ to start making withdrawals without penalty, according to the IRS. In addition, you must meet certain income qualifications to contribute to a Roth IRA — if you earn too much money, you might not be able to fund one.

If you want to open an IRA, go through a reputable broker you can trust. Fidelity Investments and Vanguard both offer commission-free trading on various securities, such as stock and ETF trades, and zero or low-expense ratio index funds, making it relatively affordable to invest. Both also offer robo-advisor options for beginner investors new to the stock market.

IRAs are designed to help you grow your retirement savings. You shouldn't make any early withdrawals unless absolutely necessary, since they usually come with hefty financial penalties.

Pros

• Tax-advantaged - With traditional IRAs your contributions are tax-deferred until after withdrawals, while Roth IRAs allow you to contribute after-tax dollars and pay no tax on the withdrawals.
• Flexible investment options - Depending on your financial institution, your IRAs could offer a variety of investment options, including commission-free stocks or exchange-traded funds.

Cons

• Low annual contribution limit - IRAs come with annual contribution limits that the IRS adjusts every year.
• Early withdrawal penalties - Different early withdrawal penalties apply according to the type of IRA. For example, traditional IRAs usually levy a 10% penalty for early withdrawals before age 59½.

If you're saving for retirement, you'll almost always want to choose an IRA over a CD for your funds. Not only does an IRA give you significant tax advantages, but it's also an investment account that can potentially earn a much higher rate of return than a CD.

However, even the safest investments come with a potential for loss. An FDIC-insured CD virtually guarantees you won't lose your money and works best for short-to-medium-term goals such as saving for a down payment for a home.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every banking story is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of banking products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

Catch up on CNBC Select's in-depth coverage of credit cards, banking and money, and follow us on TikTok, Facebook, Instagram and Twitter to stay up to date.

Enter to win an iPad from CNBC Select. We're giving away an iPad to one lucky winner who fills out our survey about personal finance interests and habits. (NO PURCHASE NECESSARY. Void where prohibited. Legal residents of the 50 US states or DC who are 18 or older. Ends 5/8/24. Limit 1 entry per person. Sponsors: CNBC Select and NBCUniversal Media, LLC.)