Show #334 Airing Sunday, 3/26/06
These days, interest rates on traditional CDs aren’t very interesting. Is there any way to get an investment that links the safety of a CD and the upside growth of the stock market? Here to link us up with the facts about index CDs is Jim Lineweaver, founder of the Lineweaver Financial Group.
Question: What is an index CD?
Answer: An index CD is a combination of a CD and a stock-market investment. These instruments seek to add the possibility of great returns to the security of CDs. They do this by pegging the interest rate paid by the CD to the performance of some stock-market index (i.e., they are linked to a market index).
Question: What are some of its features and benefits?
Answer: The CD's principal is insured by the Federal Deposit Insurance Corporation (FDIC) protection. So the investor is guaranteed 100 percent of the initial investment if he/she allows the CD to be held to maturity.
There is potential upside participation since the return is based on the underlying index. These CDs provide upside potential based on an underlying market index that provides for diversification benefits.
The CDs normally have a maturity range between 4 and 7 years. If at any time the beneficial owner passes away, the estate can redeem it for the full deposit amount.
Question: What are some of the risks attached to such an investment?
Answer: While the CD provides for a return of the deposit amount at maturity, there is not always an assurance for gains. If an investor must cash in before maturity, the CD will be subject to market risk for early withdrawal and there is no guarantee on the principal in this situation. Liquidation before maturity may be limited to certain dates during the year.
Question: Any tax implications?
Answer: Index CDs receive some unusual tax treatment. Even though you will not receive any payments from them until maturity, investors are required to pay taxes on ordinary income. The amount paid is based on the amount a comparable, conventional CD of the same term would pay.
At maturity, or if you sell or redeem the CD before maturity, any proceeds you receive above your stepped-up basis will be taxed at ordinary income rates. If the proceeds you receive are less than your stepped-up basis, you will have an ordinary loss.
Question: Is this kind of investment for everyone?
Answer: Index CDs are most appropriate for "buy-and-hold" investors who are looking to participate in the price appreciation of a broad market index while retaining protection against market decline when held to maturity. These CDs are not suited to short-term trading and have limited liquidity. You must be able to understand and bear the associated market, liquidity, and yield risk. Talk to a trusted advisor about your options.
Can an index CD meet your investment needs? To find out more, give Jim Lineweaver a call.
