Market-linked CDs are like traditional fixed-rate CDs, but instead of a fixed interest rate offered by your local bank, the rate of return is tied to a major market index like the Dow or S&P 500.
What is a Market-Linked Certificate of Deposit (CD)
When you purchase a CD, you commit to deposit a fixed sum of money for a fixed period of time — six months, one year, five years, or more — in exchange, the issuing financial institution pays you interest, typically at regular intervals. When you are ready to redeem or cash in your CD once it matures, you receive the money you originally invested plus any accrued interest.
Martket-lined CDs combine the upside potential of the stock market with the security of the traditional CD. Advantages include:
FDIC insurance–Your principal is insured to a maximum of $250,000 in aggregate for all deposits per institution for individual depositors and up to $250,000 in aggregate for all deposits per institution held in certain retirement plans and accounts, including IRAs.
Protection–Most MLCD issuers offer principal protection. As long as you do not withdraw your funds before the maturity date (normally 5 to 7 years), you are guaranteed to get your principal back.
Built-in constraints–Your funds can grow with the market but are locked up in much the same way as a traditional CD, effectively eliminating the temptation to buy and sell.
What Know Before Buying a Market-Linked CD
Participation Rate: This is the percentage at which the return of a market-linked CD will correspond to the performance of the index to which it is tied.
Interest Cap: There is usually a cap on how much interest an investor can earn.
Call Options: Some market-linked CDs have a call option which give the issuing financial institution the right to (buy) call back the CD before it matures.
Tax Implications of Market-Linked CDs
Market-linked CDs have special tax implications which differ from traditional CDs. Usually, index-based investment income is taxed according to the rate for capital gains, up to 15 percent.
Market-linked CD returns are considered interest income and taxed at the holder’s ordinary income rate. There are options for holding a market-linked CD in a tax-deferred account, such as an individual retirement account (IRA), which can help the investor to avoid paying taxes on earnings.
Early Withdrawal Penalties
Even though the principal investment is guaranteed up to the date of maturity, this is not the case for early withdrawals. There are typically significant withdrawal penalties if you tap into the account before maturity.
Market-link Certificates of Deposit are best suited for buy-and-hold investors who do not require a high level of liquidity and wish to implement an asset allocation strategy with a diversified portfolio. These CDs may also be highly beneficial for those who do not need the cash until the date of maturity (to avoid early withdrawal penalties) and wish to house the CD in a tax sheltered account (to avoid the unfavorable tax liabilities).
MLCDs may not be right for everyone. There are early withdrawal penalties, tax implications and possible high-end caps that may limit your potential returns.