A certificate of deposit (CD) can be a valuable tool for diligent savers. CDs allow you to earn higher interest rates than you would with a traditional savings account, and your returns are guaranteed at a fixed rate for the entire term of your CD. The problem is that you can’t touch your money until your CD matures (i.e. without incurring penalties).
While profits from CDs can be considerable, there are tax implications to consider. The IRS treats interest earnings from CDs as taxable income, which you must pay each year. However, there are some ways to avoid paying taxes on CD interest. Continue reading to learn how.
Generally, you have to pay taxes on the interest on the CD.
CD interest over $10 is considered taxable income, and you must report these earnings on your tax return.
CDs come in different lengths or terms. CD terms can range from one month to five years or more. Regardless of the term, you must pay taxes on the interest your CD earns.
If the term of your CD is less than one year and it matures within the same year you opened the account, you will report these earnings on your tax return that year. But if your CD’s term spans multiple years, you’ll pay taxes on the interest you earn at the end of each year. In the latter case, you would report the interest earnings on several consecutive tax returns.
You generally must pay taxes on your CD earnings regardless of how you receive interest payments. For example, you may have the option to withdraw your interest earnings before maturity, or you can reinvest the interest in your account and allow it to compound. Either way, you have to pay taxes on those profits.
Read more: Do I have to pay taxes on my savings account?
Generally, you can’t withdraw money from your CD before it reaches maturity. If you do, you will most likely have to pay an early withdrawal penalty. Many financial institutions charge these penalties based on the length of the CD term, with longer terms resulting in higher fees. Making an early withdrawal and paying the resulting fees also has tax implications.
You can deduct the amount of early withdrawal penalties from your taxable income. For example, if you pay $20 in early withdrawal penalties, you can deduct $20 from your gross income. Any early withdrawal penalties you paid must be noted in Box 2 of Form 1099-INT for that tax year.
Although you typically have to pay taxes on CD interest, there are some ways to avoid or delay it. Keeping your CDs within certain types of accounts, including IRAs, 529s, and HSAs, can help alleviate your tax burden.
Contributions to a tax-deferred retirement account, such as a 401(k) or traditional IRA, are typically tax deductible up to contribution limits. And you generally don’t have to pay taxes on your earnings until you make withdrawals in retirement.
To defer taxes on CD interest until retirement, you can open a CD within a tax-deferred retirement account, whether an employer-sponsored plan or an IRA.
Read more: Why a CD should be part of your retirement savings plan
529 plans allow you to save and invest for educational expenses while taking advantage of tax benefits.
While contributions to 529 plans are not tax deductible, you do not have to pay taxes on earnings used for qualified educational expenses, such as tuition, books, and housing. While you can invest in securities like ETFs and mutual funds within a 529, you can also invest in insured products like CDs and potentially avoid paying taxes on those CD gains.
Health savings accounts (HSAs) offer a triple tax advantage: contributions are tax deductible, interest grows tax free, and distributions are tax free when you use them for qualified medical expenses.
HSAs are a strategic tool you can use to save on healthcare costs, such as insurance premiums, prescriptions, devices, and more. But to take advantage of an HSA, you must meet certain eligibility requirements; In particular, you must be enrolled in a high-deductible health plan.
Like IRAs and 529 plans, there are a variety of investments you can purchase within an HSA, and your options depend on the financial institution that owns your account. If you invest in CDs within your HSA, you can avoid paying taxes on the interest, as long as you use distributions to pay qualified expenses.
Read more: The best CD rates on the market today
If you do not report CD interest or any other interest earnings on your tax return, you may receive a notice of unreported income (Notice CP2000). This notice highlights a discrepancy between the amount of income you reported and the amount your employer and other third parties reported to the IRS.
If you did not report CD interest on your tax return, you will have to pay the taxes you owe, plus interest, in response to receiving this notice. If you do not respond promptly, you may have to pay additional interest and penalties.
Interest income is taxed as ordinary income, meaning it is subject to the federal and state income tax rates.
Earnings from CDs are subject to state and even local taxes, and you may have to pay these taxes depending on where you live. However, not all states have income taxes. Other states have different tax structures, some with flat rates and others with graduated rates. In short, whether and how much you pay state income taxes on CD earnings depends on where you live.