Certificates of deposit (CDs) are among the safest investments available. When covered by federally backed deposit insurance, your funds are protected, up to $250,000 per depositor. But people are often confused about how CDs are taxed, so we’ll address that here.
You typically pay income tax on the interest you earn from a CD. However, CDs are treated differently in retirement accounts, and early-withdrawal penalties can potentially reduce your tax burden.
How Are CDs Taxed?
In taxable accounts (like joint and individual accounts), you typically pay income tax on the interest you earn from a CD. The IRS treats your earnings as interest income, and you generally report that income for the year in which you receive the income.
You should receive a Form 1099-INT if you earn more than $10 in interest for a calendar year. If you make less than $10, you still generally report the income to the IRS—even if you don’t receive a tax form. Financial institutions must send Form 1099-INT by Jan. 31 of each year.
When your CD matures, your bank may transfer the proceeds to your savings or checking account. That’s usually (but not necessarily always) a return of your original principal, which is not a taxable event.
Long-Term CDs (More Than One Year)
With CDs that last more than 12 months, your interest earnings may accrue in multiple calendar years. The IRS wants you to report the interest and pay taxes on your earnings as the earnings accrue. Even if you don’t withdraw funds or see a deposit in your account, you most likely need to report your earnings each year. Your bank will generally issue a Form 1099-OID to help you report the correct amount.
For example, if you buy a three-year CD that pays interest at maturity, you don’t necessarily get your interest each year. But the interest accrues each year and should generally be reported as income.
For short-term CDs or those that pay interest frequently, you get a 1099-INT each year for the earnings you received.
Whenever you have questions about how to report something on your taxes correctly, speak with a tax preparer or CPA who can provide specific guidance based on your situation.
There is no specific tax rate for interest from CDs. You pay taxes at the ordinary income rate, which depends on your income level and other items on your return. As a result, your tax rate can change from year to year, and you might pay different rates on CD income each year. The concept is similar for the income you earn at your job.
Retirement Account CDs
If you hold a CD in a retirement account like an IRA, you most likely do not owe income tax on the interest, as you earn it every year. Instead, you would incur taxes later as a result of withdrawals from the account. Your retirement account custodian should provide a Form 1099-R to help you report any distributions from retirement accounts.
When taking distributions from a pretax retirement account, you typically owe taxes on the entire amount you withdraw. That includes the original principal investment as well as interest earnings you receive.
If you’re using a Roth IRA (or other Roth account with CDs), you might not have to pay tax on the interest you earn or withdrawals from the account. But it’s crucial to follow all IRS rules to qualify for tax-free treatment. Verify the details with your CPA before taking any action.
Tax Deductions for CD Penalties
CDs are time deposits meant to be held for a specific length of time. If you pay an early-withdrawal penalty for cashing out a CD early, you may be able to deduct the amount of your penalty. Check your 1099-INT or 1099-OID to see if your financial institution included any penalties for you to report to your tax preparer.
It’s possible to pay a penalty that exceeds the interest you earn from a CD. When that happens, you walk away with less money than you initially deposited. Still, you may be able to deduct the full amount of the penalty, whether it consists of interest earnings or the penalty dips into your principal.
Tax rules are complicated, and they change regularly. Review your situation with a tax expert before making financial decisions and before submitting tax returns.
Reducing Your CD Taxes
If you’re concerned about your tax bills, meet with a Certified Financial Planner (CFP) and tax advisor, both of whom can provide advice that’s specific to your finances. It might be possible to manage the types of income you earn in different types of accounts.
For example, if you’re paying high rates on CD interest, it might be possible to shift those interest earnings to tax-deferred (or tax-free) accounts. Meanwhile, you can focus on tax-friendly holdings in your taxable accounts. Long-term capital gains and municipal bonds might get better tax treatment, but the investments involved carry risk, and you could lose money when using them.