With many online banks offering short-term CDs with annual percentage yields in the 4% to 5% range, parking your savings into a certificate of deposit feels like a guaranteed win. But all that interest you’ll accrue isn’t yours to keep.
CDs are fixed-rate investments with taxable interest. That means the government is going to ask for its share, regardless of when the CD term ends. Read on to understand how CDs will impact your bottom line at tax time.
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How are CDs taxed?
CDs are one of the lowest-risk places to stash your savings. When you open one, the bank or credit union will promise you a fixed rate of return in exchange for not touching your money for the entire term.
For example, if you deposit $10,000 in a one-year CD that pays a 5% APY, you’ll have $500 worth of interest at the maturity date.
However, the government looks at that $500 the same way it looks at the money you earn from your job: as part of your annual income.
“Interest paid on your CDs will be taxed as ordinary income just like wages when you file your taxes,” said Lisa Greene-Lewis, a certified public account with TurboTax. That means your CD interest would be taxed at your ordinary federal income tax rate based on your tax bracket. Tax rates, which range from 10% to 37%, are dependent on your income and filing status, she noted.
When do you pay taxes on a CD?
If you earn at least $10 in interest from a CD during a year, your financial institution is required to report your interest to the IRS. If you invest in a short-term CD that matures the same year it was purchased, you’ll have to pay tax on it for that year. If you invest in a long-term CD that matures after 12 months, you’ll have to pay taxes on whatever interest accrues annually along the way.
“The interest will be reported and claimed on your taxes for the year it was paid,” Greene-Lewis said.
You should receive a copy of the tax document -- Form 1099-INT -- reporting the amount of interest you earned by Jan. 31, according to Greene-Lewis. “Even if you don’t receive a copy, you still should report the interest earned on your taxes,” she said.
Are CDs subject to only federal taxes?
The interest earned on CDs is subject to federal, state and local taxation, with tax laws varying based on jurisdiction. Unless you live in a state with no income tax, you should expect to owe both federal and state taxes on your CD interest.
Since state-level tax brackets are a bit more complicated than federal tiers, you can use this breakdown from the Tax Foundation to get an estimate of the percentage of your CD earnings that will go to the state government.
To get a sense of how much taxes might eat into your overall take-home from CD interest, Fifth Third’s CD Maturity Calculator has a helpful tool for estimating your federal and state tax bill (toggle the advanced feature to access it).
How does withdrawal from a CD affect your taxes?
You’ll pay taxes on your CD interest, regardless of whether you actually withdraw the money.
For example, let’s say you open a five-year CD right now, and you’re planning to leave it untouched until the term is up. You’ll be paying taxes on interest until the CD reaches maturity, and you’d receive a 1099-INT form for every year the CD accrues interest.
If you decide to take out your money prior to maturity, most banks and credit unions will hit you with an early withdrawal penalty. While no one loves paying a fee to access their money, you can deduct the cost of the penalty on your taxes, reducing what you owe.
So let’s say you earned $70 in interest in a calendar year, but you paid $45 in an early withdrawal penalty because you needed o the funds before the term was over. You’ll only owe taxes on $35 of interest.
How do you report CD interest on taxes?
Your bank or credit union will likely mail you a copy of your 1099-INT form, or you can access the form via your online account.
The interest you’ve earned will be in Box 1 of the form. You’ll need to enter that number in the “taxable interest” section of whatever form you file with the IRS. If you earned more than $1,500 in interest and dividends -- between your CD and other investments -- you will need to file a Schedule B.
Tax reporting has loads of nuances: standard deductions versus itemized deductions, charitable contributions, mortgage interest deductions and more. It might be worth it to hire a tax professional who can make sure you’re following the appropriate guidelines and minimizing your stress. If you have other unique considerations, you’re better off with the help of an expert.
Can you delay paying taxes on CD interest?
You can’t avoid reporting the interest on your CD as income. However, you may be able to delay your payment obligation.
“You can potentially lower or avoid paying taxes on CD interest by purchasing a CD in a tax-advantaged account like an IRA or 401K,” Greene-Lewis said. By putting your CD in one of those tax-deferred accounts, you won’t pay taxes on the interest until you withdraw the funds during retirement, she said.
The upside is that you may fall under a significantly lower tax bracket when you retire. The downside is that the interest earnings from CDs are likely going to be much lower than riskier investments in the stock market. So while you can shrink your tax bill, you might be limiting your overall retirement fund.
The bottom line
CDs can be a great option for earning money without accepting any real risk. However, as you calculate your potential return from a CD, don’t forget to account for your tax bill.