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Pros and Cons of a Market-Linked CD

Some large investment companies are selling a savings and investment product called the market-linked CD, which is a certificate of deposit that pays a guaranteed return with the possibility of a higher return based on the performance of the stock market as measured by an index like the S&P 500.

At first glance a market-linked CD seems like a sure bet but it has five major pitfalls. First, if you need to cash out the CD before it matures (typically in four or five years) you may trigger a penalty charge. Note: Market-linked annuities may impose a very severe early withdrawal penalty.

Second, like any CD your returns are considered interest so you may pay a higher tax rate than the 15 percent that you pay on capital gains from long-term stock gains.

Third, the upside potential is capped so if the stock market is on the upside for the duration of your CD, you will receive only a portion of the total return. For example, if the market went up 70 percent and the cap was 60 percent, you would receive a 42 percent return.

Fourth, you do not receive dividends from the stock portion of your investment. So you don't receive the benefits of dividend reinvestment.

Fifth, the guaranteed return may be less than that of a conventional CD so if the market goes down and you receive no market return, your total return will be less than the return from a conventional CD of the same duration.

So is the market-linked CD right for you? If you plan to park money in a conventional CD anyway, the market-linked CD may be appropriate given the CD is in a tax sheltered account (to avoid the unfavorable tax liabilities) and you are sure that you will not need the the money before the CD matures (to avoid early withdrawal penalties).

The worst-case scenario is that the market goes down and you get no benefit from market returns. The best-case scenario is that the market goes up and you get the guaranteed return plus a kicker from the market.

Of course, if you are a savvy stock investor, you may be better off buying and holding stocks in a well diversified dividend-paying portfolio.