CDs are a valuable tool for diligent savers. They can earn higher interest rates than traditional savings accounts and provide a guaranteed fixed rate of return for the term of the CD. However, you can’t access the money without penalties until the CD matures.
CD earnings can be substantial, but you need to consider taxes. The IRS treats CD interest earnings as taxable income, which you must pay annually. However, there are some ways to avoid paying taxes on your CD interest. Keep reading to find out how.
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Is there tax on CD interest?
Generally, interest earned on CDs is taxable.
Any CD interest over $10 is considered taxable income, and you must report these earnings on your tax return.
CDs have a wide range of terms, or duration. They can last from less than a month to more than five years. Regardless of the duration, you’ll have to pay tax on the interest you earn on a CD. If your CD has a term of less than a year and matures in the year you opened it, you’ll report those earnings on your tax return for that year. However, if your CD has a term of more than a year, or if it spans multiple years, you’ll pay tax on the interest you earned at the end of each year. In the latter case, you’ll report the interest income on multiple successive tax returns.
Generally, you have to pay taxes on your CD earnings regardless of how you pay the interest. For example, you might have the option to withdraw the interest earnings before maturity, or you might choose to leave the interest earnings in the account and leave it there. In either case, you have to pay taxes on the earnings.
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Tax Implications of Early Termination Penalties
There are usually consequences when you withdraw principal from a CD. When you withdraw, you’ll probably have to pay . Many financial institutions charge these penalties based on the term of the CD. You’ll also incur taxes if you make an early withdrawal and pay the resulting fees.
You can deduct the amount of the early withdrawal penalty from your taxable income. For example, if you paid a $20 early withdrawal penalty, you can deduct $20 from your gross income. The early withdrawal penalty paid should be entered in Box 2 of the for that tax year.
How to avoid taxes on CD interest
Typically, you pay taxes on CD interest, but there are some ways you can avoid or delay this: Holding CDs in certain types of accounts, like an IRA, 529 or HSA, can help reduce your tax burden.
IRAs and other retirement accounts
Contributions to tax-deferred retirement accounts, such as traditional 401(k)s and , are generally tax-deductible up to contribution limits, and you generally don’t have to pay taxes on your earnings until you withdraw them 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 education expenses in a tax-advantaged way. Contributions to a 529 plan are not tax-deductible, but you won’t have to pay tax on earnings used for qualified education expenses like tuition, books, housing, etc. Not only can you invest in things like ETFs and mutual funds within a 529 plan, but you can also invest in insurance products like CDs, potentially avoiding paying taxes on CD earnings.
Health Savings Account (HSA)
Health Savings Accounts (HSAs) offer three tax benefits: 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 you can use to save money on medical expenses like insurance premiums, prescriptions, medical equipment, etc. However, to take advantage of an HSA, you must meet certain eligibility requirements. Most importantly, you must have a high-deductible health plan.
Like IRAs and 529 plans, there are many different types of investments you can purchase within an HSA, and your options will vary depending on the financial institution you hold your account in. If you invest in CDs within an HSA, you can avoid paying taxes on the interest as long as you use the distributions to pay for qualified expenses.
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Frequently Asked Questions (FAQ)
What happens if I don’t report CD interest on my tax return?
If you don’t report CD interest or other interest income on your tax return, you may receive a Notice of Under-Reported Income (Notice CP2000), which highlights a discrepancy between the amount of income you reported and the amount reported to the IRS by your employer or other third party.
If you failed to report CD interest on your tax return, you will owe tax and interest in response to receiving this notice, and you may have to pay additional interest and penalties if you do not act promptly.
How much tax will I pay on my CD interest?
Interest income is taxed as ordinary income and is therefore taxable.
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. However, not all states have income taxes. Other states have different tax systems, some with flat rates and others with progressive rates. This means that whether and how much state income tax you pay on your CD earnings depends on where you live.
