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Market-linked CDs are a type of CD where your return is tied to how certain markets perform, such as the stock market or bond market. For example, it may be linked to the Dow Jones or S&P 500.
People also call these CDs by other names, including:
- equity linked cd
- market-indexed cd
- structured cd
- index cd
How do market-linked CDs work?
A market-linked CD ties its return to the performance of a specific market index – such as the S&P 500 – rather than paying a fixed interest rate. When the index goes up, your returns also go up with it. When it performs poorly, you may earn little or nothing.
Here’s what makes them different from standard CDs:
- Your principal amount is safe. Even if the market falls, you usually get your original deposit back at maturity – the same guarantee that makes traditional CDs attractive.
- Your returns are not guaranteed. Unlike standard CDs, there is no fixed APY. A strong market year can mean much higher returns. A flat or down market can mean zero.
- Some offer minimum return floors. Some market-linked CDs guarantee small base returns regardless of market performance – but not all do. Always check the terms before committing.
The trade-off is straightforward: You are giving up the certainty of a fixed rate in exchange for the possibility of earning more if the market cooperates.
Key Benefits of Market Linked CDs
Market-linked CDs come with some benefits that investors should be aware of.
More earning potential
Market-linked CDs have a participation rate that determines how much you’ll earn as the market rises. For example, if the market goes up 15% and your CD’s participation rate is 75%, you will earn 11.25% – which is 75% of 15%. A CD’s participation rate may be higher or lower than 100%, so be sure to read the fine print.
This is different from traditional CDs and savings accounts.
- Traditional CDs have a fixed interest rate. So you know how much you will earn when the CD matures
- On the other hand, savings accounts also pay interest, but the rate can change with market conditions.
- None of these offer the potential for big gains like market-linked CDs.
portfolio diversification
A combination of traditional and market-linked CDs can add some diversity to your investment portfolio. Both types protect your original deposit but they work in different ways:
- Traditional CDs pay a fixed interest rate
- Market-linked CDs give you the opportunity to earn more if the market performs well
prime protection
The best feature of market linked-CDs is the guarantee of principal. All CDs issued by the bank are insured by the FDIC up to $250,000. This also includes market related CDs. So, although there is upside potential in market-linked CDs, there is no risk to the principal.
Who should consider market-linked CDs?
Market-linked CDs may be suitable for certain types of investors, including:
- conservative investors Those who want a chance to earn more without risking the original deposit
- retired or near retirement Who may have a low risk tolerance but are still looking for growth
- anyone looking for variety to your investments by adding a low-risk option with growth potential
Comparing commercial CDs to traditional CDs
Here’s a side-by-side comparison of market-linked CDs versus traditional CDs.
| CD type | risk | Return | liquidity |
|---|---|---|---|
| traditional cd | Less | stable, low-to-medium | Generally can be sold before maturity, but with a penalty of a few months’ interest. |
| market related cd | Less | Variable. Offers the potential for high returns but may yield returns as low as zero. | Not a guarantee that can be sold before maturity; If available, there may be a loss. |
If you’re looking for a guaranteed rate of return with regular interest payments, a traditional CD is probably a better option for you.
If you want to keep your original deposit safe and are expecting a higher return, a market-linked CD is better.
Tax implications of market-linked CDs
A major downside of market-linked CDs is that they tax owners on “phantom income.” Phantom income is money you earn but are not actually paid.
For example, if your CD earns 5% a year, that gain is added to the value of the CD but is not paid to you. Still, the IRS considers it taxable income, so you’ll have to pay taxes on it annually.
income tax
Even if your market-linked CD performs well, any gains are taxed. ordinary income — not at the lower capital gains rates you would get from holding stocks or funds directly.
Here’s why it matters:
- Long-term capital gains rates could go as low as 0%. If you have invested directly in the stock market and held it for more than a year, your gains may be taxed at 0%, 15% or 20% depending on your income.
- Ordinary income tax rates increase to 37%. Market-linked CDs do not qualify for preferential capital gains treatment, no matter how long you hold them.
- One way to reduce the tax hit: Many investors hold market-linked CDs inside a tax-advantaged account such as an IRA. This way, you don’t have to pay taxes on the annual gains – only when you withdraw money from the account.
If tax efficiency matters to you, consider this before choosing market-linked CDs instead of direct market investments.
Tips for Choosing the Right CD for the Market
Here are some tips to help you choose the best market-linked CD for your needs:
- Assess your risk tolerance and investment goals: Even though they have the name “CD” in their description, market-linked CDs are an entirely different investment type than traditional CDs. While both are suitable for investors with a low risk tolerance, traditional CDs are generally for income investors, while market-linked CDs offer limited growth potential.
- Use Online Tools to Compare CD Options:The financial services market is extremely competitive. If you shop around, you can find a variety of features and benefits, such as participation rates, term length, and withdrawal options.
- Look for reliable banks and well-defined terms: Since market-linked CDs are specialized products, it is usually best to stick with well-known, trusted banks. Since each bank can essentially create its own CD terms, you’ll want to avoid banks and products that don’t specifically outline what you’ll get when you invest in a market-linked CD.
FAQ
Here are answers to some frequently asked questions about market-linked CDs.- What is the difference between market-linked CDs and traditional CDs?
- Market-linked CDs are where your return is tied to how certain markets perform, such as the stock market or bond market. On the other hand, a traditional CD is an income investment. In addition to carrying FDIC insurance on its principal, a traditional CD is guaranteed to pay a set rate of interest at a specified maturity.
- Are market-linked CDs FDIC-insured?
- Yes, market-linked CDs are FDIC insured, just like traditional CDs and savings accounts. This means that your market-linked CD is insured up to $250,000 per issuer, per depositor, per account ownership category.
- What happens if the market performs poorly?
- As long as you hold your market-linked CD to maturity, you can’t lose money on your principal, no matter how the market performs. If the market falls during the period you hold a market-linked CD, your return will be zero, not negative.
- Can I withdraw funds early from a market-linked CD?
- Most market-linked CDs do not allow early withdrawals. However, some indexed CDs may enable survivors of a deceased depositor to cash out the full value early without paying a penalty.
- You may also be able to sell the CDs to other investors in the secondary market. Although there is no specific “early withdrawal penalty” like traditional CDs, if you want to get out of your market-linked CD before maturity you should expect to lose some money on the transaction.
- Are market-linked CDs better than stocks or bonds?
- “Better” is a relative term, especially when it comes to investing. What is good for one investor may not be the right choice for another.
- Over the long term, stocks generally deliver higher returns than market-linked CDs. However, market-linked CDs limit how much you can earn due to participation rate caps. For someone who doesn’t want to risk losing money, a market-linked CD may seem like a “better” option because it guarantees your original deposit.
- Bonds may pay higher interest rates, but they also have the risk of losing value if market conditions change. A market-linked CD may be safer, because it protects your principal while still providing you with growth potential.
Barry Segal contributed reporting to this article.
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