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CDs—certificates of deposit—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. CD interest is taxed at the rates applicable to ordinary income, up to 37% at the top federal tax bracket rate for 2023. In addition, jurisdictions with their own income tax laws tax CD interest income at their own applicable state and local rates.
The payment date for taxes on CD interest varies with the term of the CD. Tax is due on short-term CDs, those with 12-month or shorter terms, at maturity. Interest on longer-term CDs is taxed as it accrues during the CD term. IRAs that invest in CDs do not have to pay tax currently on the IRA CDs’ income or gains. Here’s what you need to know.
How are CDs taxed?
Interest earned on CDs owned directly by an individual is subject to tax at ordinary income tax rates, ranging up to 37% at the top tax bracket in 2023. Residents of states that levy their own income taxes must pay additional state tax. When a CD matures, an individual owner is taxed only on the interest; the amount that is equal to the investor’s purchase price is treated as a nontaxable return of capital. Even if an individual owner rolls over a CD at its maturity into a new CD, the owner must pay income tax on the income the CD owner is entitled to receive at that time. A rollover does not allow any deferral of taxes owed upon a CD’s maturity.
Note that if you hold CDs in your individual retirement account (IRA), the CD interest is not subject to the annual federal income tax. However, when you take a distribution of such interest and all other amounts that have not been taxed previously, you must pay tax at the applicable federal, state, and local ordinary income rates in effect at that time.
When do you pay taxes on a CD?
The due date for taxes on interest earned on CDs depends on whether the CD is a short-term or long-term CD.
- Interest on short-term CDs, i.e., those with terms of a year or less, is recognized as taxable income in the year that the CD matures.
- Interest on a long-term CD—i.e., a CD with a term greater than one year—is subject to tax as interest accrues, that is, as it is earned over the term of the CD. If you own a long-term CD, the interest is treated as taxable income in the year in which you are legally entitled to it. Accordingly, the owner of a CD with a term of four years will owe tax on the interest income accrued in each of the years that the CD is held.
Banks that issue CDs are required to report interest in excess of $10 earned during a year by a CD owner to both the CD owner and the Internal Revenue Service. The owner is obligated to report and pay tax on such taxable interest even if the bank fails to issue an information return, generally Form 1099 – INT, to the owner. If a timely information return is not received, be sure to check with your bank and get the proper tax documents.
How early withdrawal penalties affect taxes owed
Although a few banks, such as CIT Bank, offer short-term, “no-penalty” CDs, most banks charge penalties for early withdrawals on their CDs. If you withdraw CD funds prior to the maturity date, a penalty will reduce the amount you receive. The amount of the penalty usually is based on a formula that takes into account the decrease in the CD’s original term and the period you held it.
The bank will pay you any accrued interest in excess of the penalty amount plus the principal. If the penalty exceeds the accrued interest, the principal may be reduced by the remaining penalty. In reporting the tax results of an early withdrawal, banks issue an information return (Form 1099-OID) 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 as taxable income the full amount of the interest accrued and also report separately the penalty amount, which is deductible. Thus, early withdrawal penalties will reduce the taxes owed on 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 cashed in at maturity, the owner will owe tax on the interest earned. The return of principal is a nontaxable return of capital. If a CD is cashed in prior to maturity, the owner must report the interest accrued to that date as taxable income, but also can 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 the CD is cashed prior to maturity—is income. However, the tax on that income is deferred. Income realized within an IRA is not taxed 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 it out but retain the proceeds in the IRA, the amount received—i.e., the interest and the 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. Here’s what happens then:
- If the IRA received only tax-deductible contributions throughout its life, the entire amount of any distribution will be taxable as ordinary income.
- If an IRA owner made any non-deductible IRA contributions, a portion of each distribution will be treated as a tax-free return of capital.
If an IRA distribution is made before the owner reaches age 59½, the distribution is subject to an additional 10% penalty tax.
The other issue with older account holders and IRA distributions happens when the owner reaches the age when annual required minimum distributions (RMDs) are mandated. Beginning in 2023, an IRA is not required to make distributions to the owner until the year that the owner reaches age 73. Failure to take RMDs is subject to penalties.
How to report CD income on your tax return
You must report interest earned on a CD as taxable interest on Form 1040. The bank issuing the CD will send you an annual information return, Form 1099-INT and/or Form 1099-OID, that reports the taxable interest income for the year in Box 1. The interest amount should be reported on line 2 b on your Form 1040.
The bank also will send a copy of the Form 1099-INT to the Internal Revenue Service and to state income tax authorities. Note that individuals who have acquired bonds or other instruments paying taxable interest at a discount generally will receive a Form 1099-OID that reports such taxable original issue discount.
The total amount in Box 1 on the Form 1099-INT will include CD interest as well as taxable interest earned on other accounts —e.g., regular savings accounts—at the same bank, if it amounted to $10 or more. 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.
The total amount of taxable interest—on CDs and all other accounts bearing taxable interest reported on forms 1099-INT and 1099-OID—should be reported on line 2 b on the first page of your Form 1040. If the total taxable interest exceeds $1,500, you must complete Part I of Schedule B of IRS Form 1040.
For CDs cashed out prior to maturity, the Form 1099-INT and/or Form 1099-OID will report the interest income and the penalties imposed by the bank.
How to avoid being taxed on CD earnings
There are a number of opportunities to avoid or delay being taxed on earnings from CDs.
Hold them in a traditional IRA
You can defer current taxes on CD earnings if you hold that CD in a traditional IRA or similar retirement account. Income and gains received on investments in traditional IRAs are not subject to tax until the IRA makes income distributions to the owner or—if the owner is deceased—to the owner’s beneficiary. The years of tax deferral on an IRA CD’s earnings can be significant and the savings substantial.
Required minimum distributions (RMDs). No distributions from a traditional IRA are required until the year that the owner reaches age 73—or the year that the deceased owner would have reached age 73, if the decedent’s IRA is held by a surviving spouse. A surviving spouse can then take distributions calculated on the basis of the spouse’s own life expectancy. If a non-spousal beneficiary inherits an IRA, the beneficiary has 10 years to completely liquidate the IRA.
When distributed, income from a traditional IRA is treated as ordinary income and is taxed at rates up to 37%, depending on the recipient’s bracket. As noted earlier. IRA distributions prior to age 59½ years incur an additional penalty tax of 10%.
Use a Roth IRA
Roth IRAs offer low- and middle-income taxpayers a tax-free vehicle for growing investments and distributing invested capital and earnings tax-free. To qualify for this tax-free treatment, the owner of a Roth IRA must meet several requirements, which include making only non-deductible contributions, having taxable income below a specific ceiling that is set annually, and making distributions only after the Roth IRA has existed for five years.
Invest in short-term CDs
Short-term CDs offer another tax-planning opportunity. They can be used to defer taxes from one year to the next—for example, from a year when you will be earning a higher income to the next year when you expect your taxable income may be lower. Instead of holding funds in savings accounts or other investments that accrue table income, say, on a daily or monthly basis, you can invest in 12-month or shorter-term CDs that realize taxable income only at maturity.
Using CDs to save for tax payments
There’s one other way CDs can help you manage your taxes. CDs can yield a better interest rate than you would get from most savings accounts. Some taxpayers invest cash they know they’ll need for future tax payments in CDs with maturity dates just ahead of the payment dates.
Additional tax benefit: As noted above, short-term CDs purchased in one year can defer tax on interest income to the next year. By investing in a short-term CD in one year with a maturity date in early January of the next year—i.e., before the January 15 due date for the final estimated tax payment for the prior year—a taxpayer can enjoy both a better interest rate and tax deferral on the CD interest.
CDs’ wide availability makes investing in CDs for future cash needs, such as taxes, relatively straightforward. CD accounts are issued online by banks such as Discover Bank, or at a bank’s brick-and-mortar office which offers both traditional and online banking. In either case, CDs can be covered—together with all of a depositor’s other accounts with the same bank—up to a $250,000.00, under insurance provided by the Federal Deposit Insurance Corporation (FDIC).
Taxpayers considering using CDs for future tax liabilities should be aware that most banks require a $1000 minimum deposit for a CD. However, some, including Quontic Bank, have a $500 minimum. Many banks offer CDs with a minimum term of six or 12 months. Others—Nationwide is one—offer terms as short as three months.
How taxes on CDs compare to other investments
Most interest earned on debt instruments—including CDs, savings accounts, certain governmental bonds, and corporate bonds—is subject to federal, state, and local taxation at the interest rate that each jurisdiction applies to ordinary income. However, there are some exceptions.
Interest on U.S. Treasury securities generally is exempt from state and local taxation. Most federal agency bonds, however, are subject to federal, state, and local taxation. However, interest on securities issued by the Federal Home Loan Banks (FHLB) and the Federal Farm Credit Banks (FFCB) is exempt from state taxes.
Bonds issued by state, city, and local governments, called “muni bonds” or “munis” generally are free from federal taxation. Although many states also treat munis’ interest as tax-exempt, some states tax interest paid by munis. However, interest on certain municipal bonds that are issued to fund private projects and meet federal standards, i.e., “qualified private activity bonds,” is exempt from the regular income tax but is subject to the alternative minimum tax.
Corporate bonds pay interest at regular intervals, typically twice a year. An individual bondholder must pay taxes at ordinary income rates in the year that the corporate bond issuer pays the interest.
Governmental and corporate issuers may retain the right to “call,” i.e., buy back bonds before their maturity date. Such callable bonds involve a risk for holders, which is reflected in interest rates higher than those paid by non-callable bonds.
The value of a debt instrument will vary during its term, depending on fluctuations in market interest rates. If a bond is sold or “called back” prior to its maturity date for an amount that is higher or lower than its face value, the difference between the sales price (excluding interest income) and face value is treated as capital gain or loss for tax purposes.
For tax purposes, there are two types of ordinary dividends paid out of corporate earnings and profits.
- Ordinary dividends are taxed at the tax rates applicable to ordinary income, i.e., up to 37%.
- With certain limited exceptions, “qualified dividends” are ordinary dividends that are paid out of the earnings and profits of U.S. and qualified foreign corporations and meet a special holding period related to a stock’s ex-dividend date. Depending on a recipient’s income level, qualified dividends are taxed at the capital gains rates of 0%, 10%, or the maximum rate of 20%.
TIME Stamp: CDs afford modest tax-planning opportunities
CDs are conservative, secure investments that afford modest opportunities for tax planning. CDs can be scheduled to pay interest on specific dates, such as the due dates for tax liabilities. Income on short-term CDs—those with terms of 12 months or less—is taxed at maturity. Income from longer-term CDs is taxed as it accrues. Short-term CDs can be used to defer taxable income from one year to the next.
If traditional IRAs invest in CDs, taxes on CD interest and gains can be deferred until distributions occur. In the case of CDs held by Roth IRAs, income and gains from the CDs—as well income and gains from other investments—can be distributed tax-free. A tax advisor or financial planner can help you plan the most tax-beneficial ways to use CDs.
Frequently asked questions (FAQs)
If my earnings only come from a CD account, do I need to file taxes?
Determining if you are required to file a tax return depends on a number of factors: the amount of your gross income, your age, your filing status and—in cases where you have more than CD income—whether you are self-employed. In most cases, you must file if your gross income, regardless of sources, exceeds your standard deduction. However, if you are married filing separately, the threshold is $5. And you must file if you have self-employment income of $400 or more. The IRS annually publishes a chart providing the various thresholds prior to the tax return filing date.
Even if your only income is from CDs and the total is below the filing threshold, filing a return has the advantage of starting the running of the three-year statute of limitations. If the IRS discovers in the fourth year that you did not file a return because you mistakenly forgot some income, say, an IRA distribution to your savings account, the IRS can collect any tax owed plus interest. Because you failed to file, the IRS is not barred from assessing taxes owed because the statute did not even begin to run.
Could CDs be a good way to save money for taxes?
Most taxpayers pay their taxes through income tax withholding. For them, tax planning with CDs would not be relevant. However, if you pay quarterly estimated taxes on income not subject to withholding, purchasing short-term CDs that mature just prior to the four dates for filing estimated taxes in the approximate amount of tax due, would earn a higher return than holding funds in a savings account. For individuals who expect a cash bonus or other lump-sum income at year end from which taxes are not withheld, investing in a short-term CD, that matures a few days prior to January 15 of the next year in the estimated amount of the tax due on the year-end payment, could be beneficial. The CD would have a bank-guaranteed return and the CD’s interest income would be taxable in the year of receipt, and, unlike savings account interest, not in the prior year.
Do I need to pay taxes on CDs if they are held within a retirement account, such as an IRA or 401(k)?
No current taxes are due on either the interest paid at maturity, or the interest and gain or loss realized upon an early withdrawal, for a CD that was purchased by and is held in a traditional IRA or similar retirement account. In the case of a traditional IRA, income taxes apply to distributions at ordinary income rates. Unlike traditional IRAs, Roth IRAs—which are allowed only non-deductible contributions by eligible individuals—make distributions that are tax-free so you would owe no taxes.
What is the difference in tax treatment between CDs held individually and those held jointly?
All taxes owed with respect to a CD with a single owner are the responsibility of that owner. In the case of a CD held jointly, each holder is responsible for tax on the holder’s proportionate share of the CD income and gain; each also shares proportionately in any loss. If each joint holder files an individual return, the amount of tax will depend on the total income and gain reported on each return. If a married couple files a joint return, their income and gain is combined and treated in the same way as other joint return income.
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