How Are Certificates of Deposit Taxed?

The Internal Revenue Service sees income in two forms: taxable and nontaxable. Unless a particular type of income is specifically exempted from taxes by law, the IRS considers it taxable. In most cases, the interest generated by your certificates of deposit is not exempt from taxation. As with most rules, there are exceptions.

A certificate of deposit, or CD, is a low-risk investment product that requires you to leave your money on deposit for a specified period. In exchange for tying up your money, the issuer typically offers a higher interest rate than is available on demand deposit accounts, such as passbook savings or checking accounts. If you withdraw money from your CD before it matures, you'll typically face an interest penalty. The time on deposit, interest rate and early withdrawal penalties are all factors in determining how your CDs are taxed.

The interest generated by your certificate of deposit is taxable on your federal income tax return in the year that you receive it or when it is credited to your account, even if you can't withdraw it without incurring an early withdrawal penalty. Your bank, credit union or other issuing institution should provide you with a Form 1099-INT after the end of the year detailing the amount of interest paid by your CD. You must report and pay taxes on any interest from your CD, even if you didn't receive a Form 1099-INT.

Most issuers will allow you to withdraw funds from your CD before maturity, but they will impose a hefty early withdrawal penalty. You must report and pay taxes on the entire amount of interest you received from the CD. You can't reduce your interest income by the amount of the early withdrawal penalty, but you can deduct the early withdrawal penalty as an adjustment to your income by reporting the total amount of the penalty on Line 30 of Form 1040. You can claim this adjustment whether you itemize your deductions or claim the standard deduction.

You can defer the taxes on interest from your certificates of deposit if you hold them in an individual retirement account. You won't pay taxes on any growth in your IRA as long as those funds remain in your IRA. All withdrawals from a traditional IRA are taxed as ordinary income, and if you withdraw funds before reaching age 59 1/2, those withdrawals will also be subject to an additional 10 percent early withdrawal fee. If you hold your CD in a Roth IRA and you leave the earnings in the account until they become qualified, you will not owe any federal income taxes on the CD interest.