Information on Certificates of Deposit as Tied to Index Funds
When interest rates are low, certificates of deposit linked to index funds offer investors a safe place to stow money and the opportunity to earn better than average returns. Index-linked CDs have no guaranteed return, however, which means that in a down market you end up with no account earnings. These complicated products are not for everyone; before buying one, make sure you understand exactly how the CD works.
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Index Funds
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Index funds are investment funds that contain the stocks and bonds listed on a particular index, such as the Standard and Poor's 500 or the Russell 2000 index. As with all mutual funds, index funds are subject to price fluctuations and can rise or fall in value on a daily basis. Over several years, mutual funds usually grow at a faster rate than interest-paying instruments, however. Consequently, some CD issuers base the returns paid on CDs to index funds, rather than paying returns based on a fixed interest rate.
CD Duration
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Indexed CDs normally have terms lasting for at least five years. Some CD-issuers review the index on a particular day each year and pay annual returns based on any gains in the index. Other CD issuers only review the performance of the index at the end of the CD term. If an index fund grows in value between the day you buy the CD and the day the CD matures, you make money. Other index CDs reward you for market downturns or for an index staying within a particular range for a particular period. In fact, CD issuers can use almost any kind of barometer related to the index as the basis for paying out on an index linked CD. If the CD loses value during the CD term then you just get your principal back.
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Participation Rate
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A mutual fund could double or triple in value over a five-year period, but on an indexed CD you do not get the full benefit of any market gains. Indexed CD contracts include a clause that limits your participation in market gains. Some CD contracts limit your maximum return to a certain amount such as 5 or 6 percent, while for others you receive market gains up to a certain limit such as 80 percent of the gains realized by the index fund.
Other Considerations
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Penalty fees for accessing funds from an indexed CD before maturity are much higher than fees for breaking a regular CD. You often have to pay a 10 or 12 percent penalty to access your indexed CD early; you cannot make partial withdrawals. You must either close the account early or leave all of the funds in the account until maturity. Indexed CDs are federally insured, but the insurance only applies to principal and not the account earnings.
On an index-linked CD, if your returns are paid at the end of the CD rather than on an annual basis you have to pay taxes based on an estimate of your annual returns because you do not know what your returns are until the end of the CD term. This means paying taxes in the short-term for money you have yet to receive, and filing a tax amendment for prior years when your CD finally matures. You have to divide your total gains among the number of years that the CD lasted to calculate your annual returns.
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