Certificates of deposit are a solid option for investors interested in earning interest income, who might be wary of taking financial risks. One benefit of investing in CDs is that the CD yields tend to be slightly higher than interest rates that can be earned in standard savings accounts. Another advantage is the FDIC will insure your CD investment up to $250,000. The downside to CD investing is you might be subject to an early withdrawal penalty if you need to cash out of your CD earlier than expected.
Are Certificates of Deposits Taxable?
The principal of your CD, which is the money you deposited to open the account, is not taxed as part of this investment. This is because you already paid federal and state taxes on that money when you originally earned it as income. Even if you don’t touch the principal, the interest income you earn from CDs is generally counted as taxable interest in the year it is earned, creating a tax liability. It’s taxed not as a capital gain, but as a tax on interest income.
The tax rate on the CD interest earned will be the same as your income tax bracket. You must report this interest in the year that you receive it or are entitled to receive it. If you invest in a CD for longer than one year, you must include the interest income on your income tax return each year it is received. You can find the amount of interest you earned in Box 1 of the 1099-INT form tax report. The financial institution where your CD is held is required to send you a 1099-INT form by Jan. 31 in the year you are filing your taxes.
Death Taxes on CDs
Death taxes is the common term for both federal and state estate taxes as well as any inheritance applicable in your state. Estates taxes are imposed on the estate in total. If you receive an individual distribution from an estate settlement, it is not taxed to you as an individual because the tax has already been paid by the estate as a whole. Inheritance taxes, on the other hand, are charged to the people who inherit the assets. If you live in a state with an inheritance tax, you might owe state inheritance taxes on any assets you inherit, which would include CDs.
If the CD is part of an estate, it would be part of the entire estate tax only if the entire estate was required to pay taxes. For instance, in 2018, an estate must pay estate tax on any portion of the estate valued above $5.6 million. If the estate assets were valued at $6 million, a tax would be due on $400,000. State inheritance taxes do vary by state. Check your state’s tax laws or consult an accountant to understand the latest estate tax laws in your area.
CDs in Retirement Accounts
Holding a CD in a retirement account, such as a traditional IRA or Roth IRA, can defer or reduce taxes. For instance, if your CD is in a traditional IRA, you won’t have to pay taxes on the interest you earn every year. Instead, you’ll pay taxes on the interest, but not the principal, when you withdraw from your IRA during retirement.
If your CD is held in a Roth IRA, you might never pay taxes on the interest, even when you withdraw it. That’s because Roth IRAs allow investments to grow tax-free and remain tax-free. Further, unlike a traditional IRA, you’re able to withdraw your Roth IRA contributions at any time without penalty.
CD Early Withdrawal Penalty and Your Taxes
For many CDs, if you withdraw your principal before the maturity date, you’ll incur a penalty. If you earned any interest on the CD, you’ll still need to report it on your tax return as income. Remember, you’ll find this amount in Box 1 of form 1099-INT from your financial institution.
Regarding the penalty, the IRS allows you to deduct the amount of the penalty paid, it also allows you to actually deduct the entire penalty even if it’s more than you received in interest. This amount will also be on form 1099-INT, in Box 2. If you use Form 1040 for your taxes, include this amount on Line 30.
CDs can be a safe, interest-bearing investment tool, especially when combined with a retirement account. Although CDs are fairly straightforward financial instruments, be sure to explore all the tax liabilities and rules before investing. If you’re still unsure, seeking a financial advisor might be your smartest move.
Michael Keenan contributed to the reporting for this article.