Opening a certificate of deposit is a good option for anyone interested in investing but wary of taking financial risks. The benefits of CDs are that CD rates are a little higher than the interest you’ll earn on a common savings account and that they are insured by the FDIC up to $250,000. The downfall is that you’ll pay a penalty if you withdraw your money before an agreed upon period of time, usually six months to five years or more.
Even though you don’t touch the principal, the interest you earn on a CD is generally taxable in the year that you earn it. There are exceptions to taxable interest, however. Use this information to determine if and how you’ll need to pay income tax on your CD interest.
How CDs Are Taxed
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 taxes on that money when you originally earned it.
The interest you earn on your CD, however, does create a tax liability. It’s taxed not as a capital gain, but as tax on interest income, and the tax rate on CD interest 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.
Investing in CDs with terms of more than one year means that you must include part of the interest income in your income tax return each year. You can find the amount of interest you earned in Box 1 of the 1099-INT form, which the financial institution where your CD is held should have sent to you by Feb. 1, 2017.
Death Taxes on CDs
“Death taxes” is the commonly used term for both the federal estate tax and the state inheritance tax that exists in many states. If you inherit a CD, you don’t owe taxes on your federal return, but you might owe them on your state return. As for your federal tax liability, you only owe tax on the interest that the CD generates, not on the principal you inherit.
If the CD is part of an estate, however, the entire estate could owe taxes. For instance, for 2017, the estate must pay estate tax on the portion above $5.49 million, so if the estate assets were valued at $6 million, tax would be due on $510,000.
State inheritance taxes vary by state. Check your state’s tax laws or consult an accountant to know whether you owe taxes on the inherited principal amount.
CDs in Retirement Accounts
If you have a CD in a retirement account, such as an IRA or Roth IRA, this could change the CD tax implications on the interest you earn. For instance, if your CD is in an IRA, you probably 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. Remember, this doesn’t include interest earned, and if you withdraw your CD principal before its maturity date, your financial institution could still charge a penalty.
Penalties for Early Withdrawal and Your Taxes
For many CDs, if you withdraw your principal before the maturity date, you’ll incur a penalty, and if you earned any interest on the CD, you’ll 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 not only allows you to deduct the amount you pay, but 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 the help a financial advisor might be your smartest move.