Certificates of deposit (CDs) are a valuable tool for diligent savers. CDs allow you to earn higher interest rates than you would with a traditional savings account, and your returns are guaranteed with a fixed rate throughout your CD’s term. The catch is that you can’t touch your money until your CD matures without incurring penalties.
While CD earnings can be considerable, there are tax implications to keep in mind. The IRS treats CD interest earnings as taxable income, which you must pay each year. However, there are some ways to get around paying taxes on CD interest. Continue reading to learn how.
Do you pay taxes on CD interest?
Generally, you have to pay taxes on CD interest.
CD interest over $10 is considered taxable income, and you have to report these earnings on your tax return.
CDs come in varying lengths, or terms. Terms can range from less than a month to five years or more. Regardless of the term, you have to pay taxes on the interest your CD earns. If your CD’s term is less than one year and matures within the same year you open it, you’ll report these earnings on your tax return for that year. But if your CD’s term is longer than one year — or spans multiple years — you’ll pay taxes on the interest you earn at the end of each year. In the latter case, you’d report interest earnings on multiple, consecutive tax returns.
You generally have to pay taxes on your CD earnings regardless of how you receive interest payments. For example, you may have the option to withdraw your interest earnings before maturity, or you might leave interest earnings in your account and allow them to compound. Either way, you have to pay taxes on those earnings.
Read more: Do I have to pay taxes on my savings account?
Tax implications of early withdrawal penalties
You typically can’t withdraw from your CD’s principal amount without consequence. If you do, you’ll most likely have to pay early withdrawal penalties. Many financial institutions charge these penalties based on the length of a CD’s term. Making an early withdrawal and paying the resulting fees also have tax implications.
You can deduct the amount of any early withdrawal penalties from your taxable income. For example, if you pay $20 in early withdrawal penalties, you can deduct $20 from your gross income. Any early withdrawal penalties you paid should be noted in Box 2 of Form 1099-INT for that tax year.
How to avoid taxes on CD interest
Though you typically have to pay taxes on CD interest, there are some ways you can avoid or delay doing so. Holding your CDs within certain types of accounts, including IRAs, 529s, and HSAs, can help ease your tax burden.
IRAs and other retirement accounts
Contributions to a tax-deferred retirement account, such as a traditional 401(k) or IRA, are typically tax-deductible up to contribution limits. And you typically don’t have to pay taxes on your earnings until you make withdrawals in retirement.
To defer taxes on CD interest until retirement, you can open a CD within a tax-deferred retirement account — whether it’s an employer-sponsored plan 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) offer a triple tax advantage: Contributions are tax-deductible, interest grows tax-free, and distributions are tax-free when you use them for qualified medical expenses.
HSAs are a strategic tool you can use to save up for healthcare costs such as insurance premiums, prescriptions, devices, and more. But to take advantage of an HSA, you have to meet certain eligibility requirements; most notably, you have to be enrolled in a high-deductible health plan.
Like IRAs and 529 plans, there are a variety of investments you can buy within an HSA, and your options depend on the financial institution that holds your account. If you invest in CDs within your HSA, you can avoid paying taxes on the interest, provided you use distributions to pay for qualifying expenses.
Read more: The best CD rates on the market today
Frequently asked questions (FAQs)
What happens if you don’t report CD interest on your tax return?
If you don’t report CD interest or any other interest earnings on your tax return, you may receive an Underreported Income notice (Notice CP2000). This notice highlights a discrepancy between the amount of income you reported and the amount that was reported to the IRS from your employer and other third parties.
If you didn’t report CD interest on your tax return, you’ll be on the hook for paying the taxes 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’s subject to your federal income tax rate.
Are CDs taxed at the state level?
CDs 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 income tax, though. Other states have varying tax structures, some with flat rates and others with graduated rates. In short, whether you pay state income taxes on CD earnings and how much you pay depends on where you live.
Source: finance.yahoo.com