How Are CDs Taxed?

When do you pay taxes on CDs?

You must pay taxes on CD interest in the year it is credited to your account or made available to you, regardless of the term length or when you withdraw the money. So, from a tax perspective, it doesn’t matter whether your CD is short-term or long-term. No matter the case, you must report and pay taxes on the interest earned each year, even if the CD hasn’t matured or the interest is reinvested.

To avoid any confusion, let’s break it down a little bit further.

Short-term CDs (terms of 1 year or less):

• Interest earned is taxable in the year it’s credited to your account, regardless of whether you withdraw it.
• If your CD matures within the same year, you’re obligated to report all interest earned on that year’s tax return.
• Even if you don’t have physical access to the funds yet (i.e., due to maturity restrictions), you still must report and pay tax on the interest if it was credited to your account.

Long-term CDs (multi-year terms):

• Interest is still taxed annually as it accrues, not just when the CD matures.
• For example, with a 4-year CD, you’ll have to pay taxes on the interest earned in each of those four years.
• Even if the interest is reinvested or left in the CD to compound, it’s still considered taxable income

It’s important to note that differing financial institutions may credit CD interest monthly, quarterly, annually, or only at maturity. This can affect when your interest becomes taxable, so it’s important to review the terms of your CD and your bank’s crediting schedule.

How to report CD interest on your tax return

If you earn $10 or more in interest from your CD in one year, your bank will send you Form 1099-INT by January 31st of the following year, which summarizes your interest income. Even if you don’t receive Form 1099-INT, you’re still obligated to report and pay interest on all interest you earn, no matter the amount.

State tax consideration

Keep in mind that tax rules for CD interest vary by state. If you live in one of the nine states without personal income tax, you’ll only be responsible for paying federal taxes. These states include:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington**
• Wyoming

States with income tax typically treat interest accrued from CDs as ordinary income, but the exact rate you’ll need to pay depends on where you live.

Does cashing in a CD count as taxable income?

Cashing in a CD does not necessarily trigger a new tax event. When a CD matures or you cash it in, you receive the principal amount you invested plus any accrued interest. The principal is not considered taxable income as it’s merely a return of your funds. Only the interest you earned on that principal is subject to income tax, but it’s likely that you would have already paid that tax before cashing in.

Remember that any interest accrued on the CD is taxed in the year it’s earned, irrespective of when the funds were withdrawn or cashed in. So, if you’ve been paying tax on the interest annually, you generally won’t face any additional tax bill when you cash in.

Let’s look at an example. If you invest $20,000 in a 1-year CD at 5% interest, you can expect to receive $21,000 when you cash it in at maturity. Of that amount, only the $1,000 you accrued in interest is taxable, as the remaining $20,000 is a return of your original investment. Your bank will report that $1,000 on your 1099-INT, and you’re required to include it in that year’s tax return.

How early withdrawal penalties affect your CD taxes

Typically, if you withdraw money from a CD before its maturity date, your bank will charge an early withdrawal penalty fee. This penalty is usually only charged on the funds withdrawn, and not the total amount of the CD. Long-term CDs typically have higher penalties than short-term ones, often equivalent to a few months’ interest. You’ll see your exact penalty amount reflected on your Form 1099-INT.

But here’s the good news: the IRS allows you to deduct this penalty from your gross income when you file your taxes. This can help you offset your tax bill for the year that you paid the penalty.

Avoiding CD tax penalties

Though you can’t avoid being taxed on traditional CDs, you can reduce or defer those taxes by holding them inside an individual retirement account (IRA). CDs within IRAs operate similarly to standard ones, but they provide some consequential tax advantages.

Traditional IRA CDs

Contributions to traditional IRA CDs may be tax-deductible, depending on your income and if you’re covered by a workplace retirement plan. Your interest also grows tax-deferred, meaning you won’t need to pay tax on it until you withdraw the funds in retirement. Post-retirement, your income tax bracket is likely lower, so you may not have to pay as much in taxes as you would with a traditional CD.

Roth IRA CDs

Unlike traditional IRA CDs, a Roth IRA doesn’t allow you to defer your taxes, as contributions can only be made with after-tax dollars. However, all qualified withdrawals, including any interest you’ve earned, are tax-free in retirement.

Check out this table that clearly breaks down the differences between traditional and Roth IRA CDs:

Understandably, IRA CDs are a popular option for retirement savings. They combine the tax advantages of an IRA with the stability of a CD, making them especially appealing to those already planning to contribute to an IRA. The security that CDs offer compared to riskier investments is an added bonus.