How are CDs Taxed? Interest, Maturity, and Withdrawals
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Summary:
Before purchasing certificates of deposit (CDs), CD investors should know that paying tax on CD interest earned is required by the Internal Revenue Service (IRS). How much tax, and when, you will have to pay depends on your tax bracket and how you’ve purchased the CD. But typically, if you buy CDs through a bank or credit union, the interest income generated from them is considered taxable income by both state and federal governments.
Buying CDs can be a great, safe way to save your money and earn interest at a better interest rate than you could get with a typical savings account or money market account. But it’s important to know that you’ll have to pay tax on the interest income, which will take a bite out of your earnings.
Read on to learn more about how certificates of deposit are taxed, how early withdrawal penalties can affect those taxes, and ways to avoid paying tax on CD interest — at least temporarily.
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How is CD interest taxed?
Unlike stocks or bonds that are subject to a capital gains tax (which is usually lower), CD interest earnings are taxed just like regular income. So how much interest you have to pay depends on the tax rate at which your normal income is taxed. This means you could be paying income tax as high as 37%.
For example, if, because of your salary, you are in the 22% tax bracket and your interest income from CDs comes to $500, you will pay $110 in taxes on that interest earned. By comparison, if your tax rate is 37%, you would owe taxes of $185.
So regardless of how you choose to receive the interest accrued if you do earn CD interest, the financial institutions you’ve bought them through will send you tax form 1099-INT. That’s the form used to report interest income that you then have to claim on your tax return.
IMPORTANT! Keep in mind that you’ll have to pay taxes on the CD interest no matter how that money is disbursed. Usually, people either withdraw the money at the CD’s maturity date, have it deposited in a savings or checking account or reinvest it in another CD or other investment.
Buying CDs in a retirement account
On the other hand, if you buy CDs through tax-advantaged accounts such as a 401(k) or an individual retirement account (IRA), you can save some money on paying taxes on that interest. That’s because these accounts are funded with pre-tax dollars, so the money is tax deferred.
This means that although you still get accrued interest, it does not get taxed until you start making withdrawals from the account when you reach retirement age. Plus, when you retire, you’ll probably claim taxes at a lower tax rate than when you were employed, which means your tax obligation on the CDs will be lower.
Pro Tip
The exception to this is if your money is in a Roth IRA or other Roth account, as opposed to a traditional IRA or 401(k). In that case, you may not have to pay taxes at all on your CD interest, but you’ll need to make sure you adhere to IRS qualifications.
Tax considerations on early withdrawal
A CD is a timed deposit, meaning you agree to leave your investment alone for a set period of time — typically a few months to 10 years. In exchange, you receive a higher interest rate than you would with other savings methods such as a savings account or money market account.
The drawback of this situation is that if you decide you need the money sooner you will incur an early withdrawal penalty. Early withdrawal penalties can be steep and will cut into any interest accrued up to that point.
Luckily, there’s a silver lining. If you do get hit with an early withdrawal penalty, that payment can be deducted from your taxes. This means you’ll reduce your overall tax obligation for your interest earned from that CD, which can help mitigate your loss.
When you receive Form 1099-INT, it will show what you made in interest and also how much your early withdrawal penalty was. That way you know how much to deduct on your tax return.
Pro Tip
If personal finance isn’t your forte, and you have any questions about the proper way to claim interest income versus your regular income, talk to a tax professional before submitting your yearly tax returns. Being audited is no picnic, so it’s best to get your ducks in a row before you file your yearly taxes.
When do you have to pay tax on CD interest earned?
Other than with retirement accounts, you need to claim interest earnings in the tax year that you earned it. If the CD matures in the same calendar year you bought it, it earns interest on its maturity date. That means, come tax time, you’ll pay taxes on the interest you earned that year.
If it’s a long-term CD, say three years, you may not see the interest until the CD matures, but it will still accrue each year. In that case, you would just pay a portion of the total CD interest in each year that you hold the CD. Similarly, if you have multiple CDs with different maturity dates, you’ll owe the Internal Revenue Service a portion of the total interest earned on each of those CDs come tax time.
In either of these scenarios, your financial institution will send you Form 1099-OID to help you report the correct amount for tax purposes as your different CDs earn interest prior to maturity.
IMPORTANT! As mentioned earlier, if your CD interest goes into your retirement account, you won’t pay taxes until you start making withdrawals. At that point, the financial institution that holds your retirement account will mail you Form 1099-R so you know exactly how much you need to report.
Quarterly estimated tax payments
The exception to the above rules is if you happen to be someone who is required to make quarterly estimated tax payments. According to the IRS, this applies to individuals who expect to have a tax liability of $1,000 or more when they file their return.
This means taxpayers need to pay most of the tax they expect to owe during the year, as income is received. That includes earned interest in addition to normal wages earned. If you need tax advice about whether or not you should be making quarterly estimated tax payments, talk to an income tax professional for more information.
Pro Tip
Never keep all of your savings in CDs in case you need some money for an emergency. Plus, if you invest in CDs, you’ll want to keep some of your money liquid so as to cover the taxes owed from your CD income.
FAQs
How do I avoid being taxed on my certificate of deposit (CD) earnings?
You really can’t avoid paying taxes on your CD interest, but you can delay it for a while if you purchase CDs through a tax-deferred retirement account such as an IRA or 401(k). This is because contributions to retirement accounts and earned interest taxes are deferred until you start making withdrawals when you retire.
The one exception to this is if you have a Roth account or Roth IRA. In that case, you may be able to avoid paying taxes on the interest earned, but you will need to meet strict IRS qualifications.
Does cashing in a CD count as income?
When you cash out a CD, you receive the amount you initially invested plus interest. The interest portion is the only portion of the CD that counts as income. Your initial investment, or face value of the certificate of deposit, is not considered income, and therefore state and federal taxes do not apply.
Key Takeaways
- The interest earned on CDs is taxed as though it’s regular income. That means whatever tax rate you pay on your salary is the same as what you will pay on any interest income from CDs.
- Normally, you pay taxes on CD interest earned in the tax year that you received the interest.
- If you purchase CDs through a tax-deferred retirement account, like a 401(k) or IRA, you don’t have to pay taxes until you start making withdrawals at retirement age.
- If you incur an early withdrawal penalty for cashing out your CD prior to its maturity date, you can deduct that amount from your taxes. This can reduce your tax burden from CD interest earnings.
- If you have concerns about the ways in which CD interest is taxed, talk to a tax advisor before submitting your annual tax returns.
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