Subject: CDs - Market Index Linked

Last-Revised: 15 Mar 2003
Contributed-By: Chris Lott (contact me)

A market index linked CD (MILC) 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). The term on these instrument is usually around 5 years.

Like a conventional CD, the principal is fully insured by the federal government, so an investor is guaranteed to receive 100% of the original investment if the CD is held to maturity. Early withdrawal is possible, but frequently constrained to certain dates each year. Further, an investor is not guaranteed to receive 100% of the initial investment if withdrawn early.

All interest is paid when the CD matures. However, there is no guarantee that any interest will be paid. So there is very little chance an investor will do very well, but there is a reasonable chance of doing better than a conventional fixed-rate CD.

These notes have a quirky tax treatment. Although they pay no interest annually, if the CD is held in a regular account, an investor must nonetheless declare income from a market index linked CD every year. So you're probably asking, the thing paid me nothing, what am I declaring!? The amount to declare is based on the amount a comparable, conventional CD of the same term would pay, based on information in the MILC. These declared payments are added to the cost basis of the CD and the whole mess is reconciled when the CD matures. Investors can avoid this hassle by holding this instrument in a tax-deferred account such as an IRA.

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