(CD) is a valuable tool for diligent saving. 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 duration of the CD. The catch is that you can’t touch the money until your CD matures without incurring a penalty.
While CD earnings can be substantial, there are tax implications to keep in mind. The IRS considers CD interest income taxable income, which must be paid annually. However, there are several ways to pay taxes on CD interest. Read on to find out how.
Do you pay taxes on CD interest?
In general, you must pay taxes on CD interest.
CD interest of more than $10 is considered taxable income, and you must report that income on your tax return.
CDs come in various lengths, or terms. Terms can range from less than a month to five years or more. Regardless of the term, you must pay taxes on the interest the CD earns. If the term of the CD is less than one year and it matures in the same year it is opened, you will report the income on your tax return for that year. But if your CD’s term is longer than a year — or even several years — you’ll pay taxes on the interest you earn at the end of each year. In the latter case, you will report the interest income on several 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 maturity, or you may leave the interest earnings in the account and allow them to . In any case, you will have to pay tax on the income.
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Tax implications of early withdrawal penalties
You usually cannot withdraw from the principal amount of a CD without consequence. If you do, you will probably have to pay for it. Many financial institutions charge these penalties based on how long the CD is. Making early withdrawals and paying the resulting fees also has tax implications.
You can deduct the early withdrawal penalty amount from your taxable income. For example, if you pay $20 in early withdrawal penalties, you can deduct $20 from your gross income. The early withdrawal penalty you paid must be recorded in Box 2 for that tax year.
How to avoid taxes on CD interest
Although you usually have to pay taxes on CD interest, there are some ways you can avoid or delay doing so. Holding CDs in certain types of accounts, including IRAs, 529s, and HSAs, can help reduce your tax burden.
IRAs and other retirement accounts
Contributions to a tax-deferred retirement account, such as a traditional 401(k) or , are usually tax-deductible up to the contribution limit. And you usually don’t have to pay taxes on the income until you make withdrawals in retirement.
To defer taxes on CD interest until retirement, you can open the CD in a tax-deferred retirement account — whether it’s an employer-sponsored plan or an IRA.
529 plans
A 529 plan allows you to save and invest for your education expenses while taking advantage of tax benefits. While contributions to a 529 plan are not tax-deductible, you don’t have to pay taxes on the income you use for qualified educational expenses, such as tuition, books, and housing. While you can invest in things like ETFs and mutual funds in a 529, you can also invest in insured products like CDs and potentially avoid paying taxes on those CD earnings.
Health Savings Account (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.
An HSA is a strategic tool that can be used to save on health expenses such as insurance premiums, prescriptions, devices, and more. But to take advantage of the HSA, you must meet certain eligibility requirements; In particular, you must be enrolled in a high-deductible health plan.
Like IRAs and 529 plans, there are a variety of investments you can buy in an HSA, and your choice depends on the financial institution that holds your account. If you invest in CDs in your HSA, you can avoid paying taxes on the interest if you use the distributions to pay qualifying expenses.
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Frequently asked questions (FAQs)
What happens if you don’t report CD interest on your tax return?
If you did not report CD interest or other interest earnings on your tax return, you may receive an Underreported Income notice (CP2000 Notice). This notice highlights the difference between the amount of income reported and the amount reported to the IRS from employers and other third parties.
If you don’t report CD interest on your tax return, you’ll be on the hook for paying the tax you owe, plus interest, in response to receiving this notice. If you don’t respond promptly, you may have to pay additional interest and penalties.
How much tax will I pay on CD interest?
Interest income is taxed as ordinary income, meaning it is subject to .
Are CDs taxed at the state level?
CD earnings are subject to state and even local taxes, and you may have to pay these taxes depending on where you live. Not all states have an income tax, though. Other countries have different tax structures, some with flat rates and others with graduated rates. In short, whether you pay state income tax on your CD earnings and how much you pay depends on where you live.
