A certificate of deposit, or CD, can be a good place to invest cash you won't need for a while, such as money for college or grad school. You'll tie up your funds for a determined period, usually between six months and five years, but you'll earn higher interest than you would on most savings accounts. In many cases, however, you must claim the interest on your federal taxes even before you cash your CD.
If you buy a six-month CD in January and cash it during the same year, there's no surprise. You'll get your interest before the end of the year and claim it on your federal taxes for the year you receive it. However, if you have CD with a maturity greater than one year, you must report the interest earned every year, according to the Internal Revenue Service. This rule applies to any type of savings certificate or time deposit at banks and other savings institutions.
Understanding the Logic
You'll usually have to pay a penalty if you want to touch your original investment in a CD before the account matures. However, banks typically allow you to withdraw the interest from CDs as soon as it's credited without any penalty. In general, the IRS considers that you've already received any interest that's been added to your account and that you can withdraw it without penalty. It doesn't make any difference whether or not you actually take it out.
You normally won't have trouble figuring out how much CD interest to claim on each year's income tax. The IRS requires every savings institution to send you a Form 1099-INT listing the taxable interest on your CDs and other accounts. These forms normally arrive after the end of the tax year in January or early February, and you can't cheat, because the IRS also receives a copy. Save your 1099-INT forms for tax filing time. However, you must claim any taxable interest even if a 1099 fails to arrive. Contact your bank to ask for a copy.
In most cases, you can report your CD and other interest income on line 8a of IRS Form 1040 or 1040 A or on line 2 of Form 1040EZ. If you have more than $1,500 in interest from all sources, however, you must choose either Form 1040 or 1040A. You must also complete Schedule B, the Interest and Ordinary Dividends form, listing CD and other interest income under line 1.
The IRS requires savings institutions to report interest yearly on CDs that have terms of longer than a year. However, sometimes banks may report interest on a yearly basis for shorter CDs. If the bank allows you to withdraw interest without a penalty, it's normally taxable, even before maturity. If the bank makes a mistake on the form, try asking for a new 1099-INT, suggests George Saenz of Bankrate. Otherwise, you'll have to claim the amount on your 1099-INT on your taxes. Prevent unpleasant surprises by finding out your bank's policy on reporting interest before you open a CD.
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