Certificates of deposit (CDs) are 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 life of the CD. The catch is that you can’t touch your money until after the CD matures without incurring penalties.
While CD earnings can be substantial, there are tax implications to consider. The IRS treats CD interest earnings as taxable income, which you must pay each year. However, there are a few ways to get around paying taxes on CD interest. Read on to learn how.
Do you pay taxes on CD interest?
Generally, you have to pay taxes on CD interest.
CD interest over $10 is considered taxable income, and you must report this gain on your tax return.
CDs come in different lengths, or terms. Terms can range from less than a month to five years or more. Regardless of the term, you have to pay taxes on the interest your CDs earn. If your CD has a term of less than one year and matures the same year you open it, you’ll report those earnings on your tax return for that year. But if your CD has a term longer than one year — or spans multiple years — you’ll pay taxes on the interest you earn at the end of each year. In the latter case, you’ll report the interest earnings on multiple consecutive tax returns.
You generally have to pay taxes on your CD earnings regardless of how you receive the interest payments. For example, you may have the option to withdraw the interest earnings before the maturity date, or you may leave the interest earnings in your account and let them go. In either case, you have to pay taxes on those earnings.
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Tax Implications of Early Withdrawal Penalties
You typically can’t withdraw the principal amount of your CD without consequences. If you do, you’ll likely have to pay. Many financial institutions charge these penalties based on the length of the CD’s term. Early withdrawals and the resulting fees also have tax implications.
You can deduct the amount of any early withdrawal penalties from your taxable income. For example, if you paid $20 in early withdrawal penalties, you can deduct $20 from your gross income. Any early withdrawal penalties you paid must be recorded in Box 2 for that tax year.
How to Avoid Taxes on CD Interest
Although you typically have to pay taxes on CD interest, there are some ways you can avoid or delay doing so. Keeping your CDs in certain types of accounts, including IRAs, 529 accounts, and health savings accounts, can help ease your tax burden.
Individual Retirement Accounts and Other Retirement Accounts
Contributions to a tax-deferred retirement account, such as a traditional 401(k) or a tax-deferred retirement account, are typically tax-deductible up to the contribution limit. You typically don’t have to pay taxes on your earnings until you withdraw them in retirement.
To defer taxes on CD interest until retirement, you can open a CD within a tax-deferred retirement account — either an employer-sponsored plan or an IRA.
529 plan
529 plans allow you to save and invest for education expenses while taking advantage of the tax benefits. While contributions to 529 plans are not tax deductible, you won’t have to pay taxes on earnings used for qualified education expenses, such as tuition, books, and housing. While you can invest in things like ETFs and mutual funds within a 529 plan, you can also invest in insured products like certificates of deposit (CDs) and avoid paying taxes on the earnings from those CDs.
Health Savings Accounts (HSA)
Health Savings Accounts (HSAs) offer a triple tax advantage: Contributions are tax-deductible, interest grows tax-free, and distributions are tax-free when used for qualified medical expenses.
Health savings accounts are a strategic tool you can use to save money to cover healthcare costs such as insurance premiums, prescriptions, medical devices, and more. But to take advantage of health savings accounts, you must meet certain eligibility requirements; the most important of which is being enrolled in a high-deductible health plan.
As with IRAs and 529 plans, there are a variety of investments you can buy in an HSA, and your options depend on the financial institution that holds your account. If you invest in CDs in an HSA, you can avoid paying taxes on the interest, provided the distributions are used to pay qualified expenses.
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common questions
What happens if you do not report CD interest on your tax return?
If you do not report CD interest or other interest earnings on your tax return, you may receive a Notice of Unreported Income (CP2000 Notice). This notice highlights the discrepancy between the amount of income you reported and the amount reported to the IRS by your employer and other third parties.
If you do not report interest on CDs on your tax return, you will be responsible for paying the taxes you owe, plus interest, in response to receiving this notice. If you do not respond promptly, you may be required to pay additional interest and penalties.
How much tax will I pay on CD interest?
Interest income is taxed as ordinary income, which means it is subject to your income tax.
Are CDs taxed at the state level?
CD earnings are subject to state and local taxes, and you may have to pay these taxes depending on where you live. However, not all states impose income taxes. Other states have different tax structures, with some charging flat rates and others having graduated rates. In short, whether you pay income taxes on CD earnings and how much you pay depends on where you live.