IRAs – FAQs

What are the risks with investing in IRA CDs?

Many will say, they are risk-free. But that just isn’t true. IRA CDs have inflation and potential duration risk. Inflation risk is when the rate of return may not keep pace with real inflation. If the CD is only paying 2% and your cost of living is rising at a greater level, the CD’s earnings won’t keep pace. Thus, you’ll have your principal and interest at the end of the term, but the buying power of those dollars will have been eroded.

Duration risk usually comes into play with longer-term CDs. For instance, if you purchase a 5-year CD at 2.00% and during the term rates go up substantially, like to 4.00% in two years, you are locked in for another three years at the 2.00% (although you may be able to close your CD early and move it). So there is a risk that your CD will last too long at a lower rate. Of course, if you purchased a 10-year CD at 6.00% back in 2006 or 2007, you now look like a prophet (not to mention liking the profit).

What is the Early Withdrawal Penalty (EWP), does it decrease or increase as the CD progresses, and can it change?

If the bank has a fixed penalty (ie 1 Year) it would not increase, it would be one year’s interest no matter when you closed it. There are banks, however, who may charge their penalty differently than the basic fixed penalty. Some are, “All interest earned” or “replacement cost”. Replacement cost can get complicated so we prefer to stick to the fixed term penalties if it’s a CD you may eventually close early. Here are the specifics on a replacement cost penalty: Replacement cost estimates the interest cost that we would incur if the bank were to replace your early withdrawal or closed CD with another “replacement CD” at a higher cost. The replacement CD would be of a term that is closest to but not greater than the remaining term of your original CD. To calculate the Market Adjustment, the bank takes the difference between the (lower) interest rate on your original CD and the (higher) interest rate on the replacement CD and apply this difference to the amount being withdrawn, multiplied by the number of years (or partial year) remaining on your original CD. If the interest rate on the replacement CD is less than or equal to the interest rate on your original CD, there is no applicable Market Adjustment.

The last question is more frustrating. Historically, a CD has been a straightforward contract that you enter into with the bank. In the past, they were quite simple. You agreed to let the bank keep the funds for a specified amount of time and the bank agreed to pay you a set interest rate. Various things could occur during the term that would cause someone to need their funds back. Thus, the penalty for early closure. However, banks have begun to use very vague disclosures (see: Main Street Bank of Texas) and a credit union recently modified their early withdrawal penalties and made it retroactive (Fort Knox Federal Credit Union). Both of those are very disturbing developments. So read the disclosures very carefully. If one is vague get a bank officer to sign an additional letter that would fix the penalty for your CD.

Does the bank send the Required Minimum Distribution (RMD) amount on a monthly basis or all in one lump sum?

From our experience, banks usually send it in one lump sum instead of monthly.  However, IRS rules do allow you to collect it monthly, quarterly, or however, as long as the required amount is received by the end of the year.  So if you need the income, the bank may be willing to send it more frequently.  Keep in mind that doing so will reduce your overall earnings as less is available to compound.

Here is a link to a tool that can help you calculate your RMD: http://www.bankrate.com/calculators/retirement/ira-minimum-distribution-calculator-tool.aspx.

Will a bank charge an EWP on my RMD?

For the amount of the RMD that the bank or credit union is required to send, no. However, if you have multiple IRA CDs at multiple banks, and you want to take the total required RMD from only one of the banks, the bank may charge an EWP on the withdrawal that is above their portion.

Also keep in mind that although banks will calculate your RMD it your responsibility to make sure they are correct. Not having the correct amount distributed can result in substantial penalties.

Update: After a few phone calls from clients and some research we discovered that in most cases you can consolidate your RMDs with a single bank or credit union (if you have multiple accounts). You won’t be charged a penalty on any portion of that. You will most likely need to complete a form to provide evidence that the amount requested is the total RMD you are required to take.

If I close an IRA early, is the penalty amount considered a distribution?

No, the penalty would be taken from the IRA before it is transferred. The penalty amount is not considered a distribution and it will not be taxed or penalized.

If I transfer my funds to an IRA CD, will it be easy to transfer out?

IRA transfers are heavily regulated.  Just as your custodian can transfer the the funds to the bank or credit union of your choice, that same bank or credit union can transfer it back.

We recommend doing trustee-to-trustee or direct transfers between the two.  It can take a little longer, but it won’t create a potential taxable event. 

What is the best way to transfer my IRA?

There are two methods of transferring an IRA. The first is where you take a distribution for an existing account and re-invest the funds on your own into another IRA. The is usually the fastest way, but not necessarily the best. You have 60-days to complete another IRA and you can only do this once a year. If the funds are not moved with an 60-days you will have to pay the taxes on the amount withdrawn. In addition if you are under 59 1/2, you will also have to pay a penalty (which I believe is 10%).

The safest method is a trustee-to-trustee transfer. This is where you direct your current holder (custodian) of the IRA to directly transfer the funds to the new custodian (the bank or credit union if you are doing a CD). Since you are not taking possession of the funds, no potential taxable event is created. The current custodian usually mails the funds. But if you can convince them to wire the money, the process will go much faster.

How long will it take to tranfer my IRA?

Our experience with IRAs is it usually takes two to three weeks for the transfer to be completed. Many institutions don’t lock the rate in until the funds are received. For IRAs, we usually recommend a trustee-to-trustee transfer. It can take a little longer, but you don’t have to worry about a taxable event being created.

The time delay is caused by the need for original and often notarized or gold medallion signature guarantees. This means the transfer form is often going from you to the new bank or credit union and from them to your current custodian. Using overnight delivery services can greatly reduce this, but then it also adds to the expense.

The second delay comes from the current custodian. They often will only mail the funds. If they can wire them and you use overnight delivery services, you can complete an IRA in a few days.

How are my beneficiaries handled?

When setting up your IRA CD, there is usually a form or spot on the form to list your beneficiaries.  Keep in mind if you are married and your spouse is not marked as the primary and receiving at least 50%, they have to approve the percentages.

Are these institutions set-up to handle Inherited IRAs?

If during the term, you meet an unfortunate demise, understand IRAs are heavily regulated and standardized.  Yes, the institution will be able to transfer the IRA and handle it as an Inherited IRA.  There are a few things to keep in mind and some ramifications depending on the option you select.  Since we aren’t tax professionals or attorneys I will refer you to a guide that Charles Schwab put together:  http://www.schwab.com/cms/P-1625576.3/CS13416-02_MKT13598-10_FINAL_118091.pdf?cmsid=P-1625576&cv7.

Are direct bank IRA CDs more risky then what my brokerage account offers?

Direct IRA CDs are not inheritantly more risky then brokerage CDs.  The fact is anytime you are setting up new accounts, humans are involved one way or another, and no human is perfect.  The risk comes that you are moving an established, already set-up account.

The question was brought to our attention because the potential client’s broker warned him that the new CD could be coded wrong.  And although this is true, it is also possible for the broker or his office staff to code any new purchases wrong.  Humans are not perfect.

First let me say, that none of our clients have ever had one of the CDs we referred them to coded wrong.  However, these clients have had CDs coded wrong elsewhere.  99% of the time, it was corrected with a simple phone call.  Occasionally a letter or form was needed.  If the error is caught early, no “damage” would be done.  If not caught early, some IRS forms may need to be completed.

So the big question is, Is the extra yield worth the trouble of the initial transfer and dealing with with an unlikely error?  Only you can decide that.  We can provide you estimated earnings so at least you can put some dollars and cents into the equation.