Are you considering investing in certificates of deposit (CDs) but unsure if they are taxable? Well, we have all the information you need! In this guide, we will explain everything you need to know about the taxation of CDs. Let’s dive in!
How are CDs taxed?
CDs provide holders with taxable interest income. They are fixed-income investments issued by banks and pay interest at a stated rate for a specific time period. The interest earned on CDs is taxed at the rates applicable to ordinary income, up to 37% at the top federal tax bracket rate for 2023. Additionally, jurisdictions with their own income tax laws tax CD interest income at their own applicable state and local rates.
When do you pay taxes on a CD?
The due date for taxes on CD interest depends on the term of the CD. For short-term CDs with terms of 12 months or less, taxes are recognized as taxable income in the year the CD matures. On the other hand, interest on long-term CDs is subject to tax as it accrues over the term of the CD. So, if you own a CD with a four-year term, you will owe tax on the interest income accrued in each of the years that the CD is held.
How early withdrawal penalties affect taxes owed
Most banks charge penalties for early withdrawals on their CDs. If you withdraw CD funds before the maturity date, a penalty will reduce the amount you receive. In reporting the tax results of an early withdrawal, banks issue an information return that states the amount of interest accrued until the date of the withdrawal, as well as the amount of the penalty. When you withdraw money early from your CD, you must report the full amount of the interest accrued as taxable income, but you can deduct the penalty amount. Therefore, early withdrawal penalties will reduce the taxes owed on the interest income that has accrued up to the date of the withdrawal.
Does cashing in a CD count as income?
Cashing in a CD directly held by its owner is a taxable event. If you cash it in at maturity, you will owe tax on the interest earned, while the return of principal is a nontaxable return of capital. If a CD is cashed in prior to maturity, you must report the interest accrued to that date as taxable income, but you can also deduct any penalty charged by the bank. In the case of a CD purchased and cashed in by a traditional IRA, the full amount received, both principal and interest (less any penalty if cashed before maturity), is considered income. However, the tax on that income is deferred until there is a distribution to the IRA owner.
If I cash out an IRA CD after age 65, how am I taxed?
If you cash out an IRA CD but retain the proceeds in the IRA, the amount received, including the interest and principal, is not taxed at that time, regardless of your age. Income and gains realized in an IRA are not taxed until the IRA makes a distribution to the owner. However, if you receive a distribution from an IRA after reaching age 59½, it will be subject to income tax at ordinary income rates.
How to report CD income on your tax return
You must report the interest earned on a CD as taxable interest on your tax return. The bank issuing the CD will send you an annual information return that reports the taxable interest income for the year. The interest amount should be reported on your tax return. The bank will also send a copy of the information return to the Internal Revenue Service and state income tax authorities. If you have additional CDs and/or other taxable accounts at several banks, each bank will provide you with information returns stating your total taxable interest income for the year.
How to avoid being taxed on CD earnings
There are several strategies to avoid or delay being taxed on earnings from CDs:
- Hold them in a traditional IRA: By holding a CD in a traditional IRA, you can defer current taxes on CD earnings until distributions occur.
- Use a Roth IRA: Roth IRAs offer the opportunity to distribute invested capital and earnings tax-free, as long as specific criteria are met.
- Invest in short-term CDs: Short-term CDs can be used to defer taxable income from one year to the next.
- Use CDs to save for tax payments: CDs can yield higher interest rates than savings accounts, making them ideal for saving money for future tax payments.
How taxes on CDs compare to other investments
Most interest earned on debt instruments, including CDs, is subject to federal, state, and local taxation at the applicable interest rate for ordinary income. However, there are exceptions. For example, interest on U.S. Treasury securities is generally exempt from state and local taxation. Municipal bonds may also have different tax treatments depending on the issuer.
In summary, CDs afford modest tax-planning opportunities. They can be scheduled to pay interest on specific dates, used to defer taxable income, or held within retirement accounts for tax advantages. It’s always a good idea to consult with a tax advisor or financial planner to determine the most tax-beneficial ways to use CDs.
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