Certificates of deposit (CDs) can be a great option for those who are serious about saving. With CDs, you can enjoy higher interest rates compared to a regular savings account, and you can count on a fixed rate for the entire term of your CD. Just keep in mind that you’ll face penalties if you need to access your money before your CD matures.
When considering CD earnings, it is important to remember that there are tax implications to take into account. The IRS considers CD interest earnings as taxable income, which means you must pay taxes on them annually. However, there are some strategies that can help reduce or eliminate taxes on CD interest. Keep reading to find out how.
Do you pay taxes on CD interest?
Generally, you have to pay taxes on CD interest.
Any interest earned on a CD that exceeds $10 is classified as taxable income, so you’ll need to include these earnings when filing your tax return.
CDs have different lengths, or terms. These terms can vary from less than a month to five years or even longer. Regardless of the term, taxes must be paid on the interest earned by your CD. If your CD’s term is under one year and matures within the same year it was opened, you will need to report these earnings on your tax return for that year. However, if your CD’s term is over one year, or spans across multiple years, you will pay taxes on the interest earned at the end of each year. In this scenario, you will report interest earnings on several consecutive tax returns.
You typically need to pay taxes on the interest you earn from your CD, whether you choose to withdraw it early or let it compound in your account.
Tax implications of early withdrawal penalties
Generally, you can’t take money out of your CD’s principal without facing some consequences. If you decide to do so, you will likely incur early withdrawal penalties. Many banks and credit unions determine these penalties according to the duration of the CD’s term. Additionally, making an early withdrawal and paying the associated fees can also affect your taxes.
You have the option to subtract the total of early withdrawal penalties from your taxable income. For instance, if you incur a $20 early withdrawal penalty, you can subtract $20 from your total income. Make sure to record any early withdrawal penalties paid in Box 2 of Form 1099-INT for the corresponding tax year.
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How to avoid taxes on CD interest
You usually need to pay taxes on CD interest, but there are strategies to avoid or postpone this. Keeping your CDs in specific accounts like IRAs, 529s, and HSAs can reduce your tax liability.
IRAs and other retirement accounts
When you contribute to a tax-deferred retirement account like a traditional 401(k) or IRA, those contributions are usually tax-deductible, up to certain limits. Plus, you generally won’t owe taxes on your earnings until you start taking withdrawals during retirement.
If you want to postpone taxes on the interest from a CD, consider opening one within a tax-deferred retirement account, whether it’s through your employer or an IRA.
529 plan
529 plans allow you to save and invest for educational expenses while taking advantage of tax benefits. While contributions to 529 plans aren’t tax-deductible, you don’t have to pay taxes on earnings used for qualified educational expenses, like tuition, books, and housing. While you can invest in things 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 earnings.
Health savings accounts (HSAs)
Health savings accounts (HSAs) provide a fantastic triple tax benefit: You can deduct contributions from your taxable income, the interest accumulates without being taxed, and when you withdraw funds for eligible medical expenses, those distributions are also tax-free.
HSAs can be a valuable resource for saving money for healthcare expenses like insurance premiums, prescriptions, and medical devices. However, in order to utilize an HSA, you must meet specific eligibility criteria, including being enrolled in a high-deductible health plan.
Just like IRAs and 529 plans, there are different investment options available within an HSA. The investments you can purchase will vary depending on the financial institution where your account is held. If you choose to invest in CDs within your HSA, you can potentially benefit from tax advantages on the interest earned, as long as you use the distributions for eligible expenses.
Frequently asked questions (FAQs)
If you fail to disclose CD interest or any other interest earnings on your tax return, you could end up getting an Underreported Income notice (Notice CP2000). This notice points out a difference in the income you reported and what was reported to the IRS by your employer and other third parties.
Not reporting CD interest on your tax return means you’ll have to pay the taxes you owe, along with interest, once you receive this notice. Failing to act quickly could result in having to pay extra interest and penalties.
Interest earnings are taxed at the regular income rate, which implies that it will be affected by your federal income tax bracket.
CD earnings may be subject to state and local taxes, so you might need to pay these taxes based on your location. Keep in mind that not all states impose income tax. Each state has its own tax system, with some having flat rates and others having graduated rates. Ultimately, the amount of state income tax you owe on CD earnings is determined by where you reside.