If you open up a certificate of deposit, or CD, at your bank, you may earn a higher rate of interest than with a traditional savings account. Unlike most savings accounts, pulling money out of your CD early may come with penalties. But regardless of whether you leave the money in your CD until it matures or you pull it out early, only the interest portion is considered taxable income.
Whether you withdraw money from a mature CD or take money out early, you won't pay tax on the principal you deposited, only the interest.
Taxes on CD Withdrawals
To open up a CD account, it generally requires a one-time deposit that's supposed to remain in the account until the CD's maturity date – the day you can withdraw all of the money deposited and the accrued interest without penalty. Financial institutions offer CDs with various maturity dates, which can be six months, one year, three years, five years or even longer. For example, if you deposit $10,000 into a one-year CD that pays 3 percent interest, the maturity date is one year from the day you make the deposit. On this day, you'll get your $10,000 back plus $300 for the accrued interest. If your financial situation changes, and you need to pull the money out of the CD early, meaning any withdrawal you make prior to the CD's maturity date, the financial institution may penalize you by paying you less interest.
For tax purposes, it doesn't matter when you actually withdraw the money from your CD. You always recover your initial deposit tax-free – meaning it isn't considered taxable income. The interest you earn, however, is always taxable income in the year it's credited to your CD account. To illustrate, suppose you opened that aforementioned one-year CD on July 1, 2018. At the end of the 2018 tax year, you'll report six months of interest, or $150, as taxable income on your return and the remaining $150 of interest on your 2019 return. The CD tax rate is simply your ordinary income tax rate, as with other bank interest.
Reporting CD Withdrawals
Because the Internal Revenue Service taxes interest as it accrues in your CD account during the year, the tax implications are the same regardless of whether you leave the money in the account until the maturity date or withdraw it early. Withdrawing the funds early may, however, reduce the amount of interest you'll report, which can ultimately save you money in tax. Moreover, your initial deposit remains nontaxable. The IRS doesn't penalize you for withdrawing it early. At the close of each tax year, your financial institution will send you a Form 1099-INT that reports the amount of taxable interest you earned. It isn't necessary to send Form 1099-INT to the IRS with your return, rather you'll just transfer the amount of “Interest income” reported in box 1 to the appropriate line of your tax return, though your 1099-INT may include other important tax-related information to report as well.
If you do pull money out of a CD early, the 1099-INT you receive that year may report an “Early withdrawal penalty” in box 2. Your interest income, reported in box 1, includes the penalty, or forfeited interest rather, in box 2. To avoid paying tax on forfeited interest, the IRS lets you take a deduction for the early withdrawal penalty as an adjustment to income. This is a deduction that reduces your total income to arrive at your adjusted gross income. You can take it without itemizing your deductions.
Special Types of CD Accounts
The penalty for taking money out of a CD can vary, and some banks may offer special programs that let you pull out funds at certain times with minimal penalties, add more money to the CD or boost the interest rate if prevailing rates change. Make sure you understand the terms of a CD or any other bank account before you set it up.
2018 Tax Law Changes
Tax laws around interest payments aren't changing for 2018. Overall, tax rates are declining, so you may owe less in tax on a similar amount of interest in 2018 than you would have in previous years.
- Internal Revenue Service: Topic 403 – Interest Received
- Internal Revenue Service: Form 1099-INT
- Internal Revenue Service: Instructions for Form 1040 (2018 Draft)
- Ally Bank: No Penalty Certificate of Deposit (CD)
- First Merchant Bank: Smart Saver CD
- Forbes: New: IRS Announces 2018 Tax Rates, Standard Deductions, Exemption Amounts And More
- Board of Governors of the Federal Reserve System. "Compliance Guide to Small Entities: Regulation DD: Truth in Savings." Accessed Sept. 15, 2020.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.