Which Is Better: a CD, 401(k), or Mutual Funds?

Certificates of deposit and mutual funds are two types of investment instruments. Which investment is a better option depends on a number of factors that make up the investor's goals. These include tolerance to risk, time horizon and need for liquidity. A 401k is a tax-deferred, employer-sponsored retirement plan that may be used to hold these financial instruments.

Certificates of deposit (CDs) are time deposits typically issued by banks, credit unions and similar financial institutions. CDs offer a fixed rate of interest in return for the depositor agreeing to leave the CD in deposit for a fixed term, typically between three months and five years. Early withdrawal usually carries a substantial early withdrawal penalty. Most CDs are generally considered nearly risk-free, as most deposits to $250,000 are insured by the Federal Deposit Insurance Corp., a U.S. government agency.

Mutual funds are financial intermediaries that pool the investment resources of individuals, companies and institutions. The pooled funds are used to invest in a portfolio of assets, which may include stocks, bonds, commodities, money market instruments, cash and financial derivatives. Mutual funds differ based on the financial objective of the fund. Investments in mutual funds are not guaranteed and many mutual funds can and do lose value.

A 401k is a retirement plan named after the section of the Internal Revenue Code authorizing it. These plans are typically employer created and sponsored. A 401k plan allows a wide range of investment options, although the investment options for any particular plan are governed by the administrator's investment selections. Most 401k plans allow for investments in mutual funds and some 401k funds authorize the investment in CDs. Like mutual funds, investments in 401k plans are not insured and can and do lose value.

CDs are considered highly secure, short-term investments appropriate for investors without a long-term investment horizon. Investment yields in CDs are usually very modest and the lack of risk in the investment is usually the key factor in investment decisions.

Yields in mutual funds vary, and to a certain respect depend on the investment objective of the fund. The vast majority of mutual funds aim to return investment yields significantly greater than those of CDs.

The investment yields of 401k plans are dependent upon the chosen investment options in the plan. Most plans offer a variety of options ranging from near cash-equivalents to high-risk growth.

CDs are the least tax efficient of these investment options. The interest earned on CD accounts is taxable to the investor annually as interest income, taxable at ordinary income rates. Many mutual funds offer some tax deferral options and income from long-term investments in certain capital assets, such as stocks, may qualify for reduced tax rates.

A 401k is a tax deferred investment. In general, contributions to a 401k plan are not taxed until distribution, allowing the value of the portfolio to grow without the investor paying tax.