Are CDs taxable? Yes, they are. However, not all the money within the CD is subject to taxation.
Generally, 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.
Read More: Who Must File Income Taxes?
Making 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 three 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.
Paying CD Tax
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. You must report any interest amounts of $10 or more that you earn. Plus, you may need to pay income tax on the CD interest at some point.
To illustrate, suppose you opened that aforementioned one-year CD on July 1, 2020. At the end of the 2020 tax year, you reported six months of interest, or $150, as taxable income on your return and the remaining $150 of interest on your 2021 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.
2021 Tax Law Changes
Ordinary income rates and standard deductions have been adjusted for inflation, although the top income bracket remains 37 percent. Since interest income tax is usually based on that, it would be best to watch out for the new limits.
For example, if you file as a single, you can claim up to $12,550 in standard deductions. But if you file a joint return, your deductions can be as much as $25,100. Also, heads of households can claim deductions of up to $18,800.
On the other hand, the 37 percent tax rate applies for single filers earning $523,600, while married couples filing joint returns can earn $628,300 before the top rate takes effect.
In addition, there is a Net Investment Income Tax (NIIT) of 3.8 percent that could be imposed on you if your investment income exceeds the statutory thresholds. These thresholds range from $125,000 to $250,000, depending on your filing status.
- Investor.Gov: Certificates of Deposit (CDs)
- IRS.Gov: Topic No. 403 Interest Received
- IRS.Gov: Publication 550 Investment Income and Expenses
- CNBC: You can earn more interest when you put your money in a CD—here are the different types offered
- IRS.Gov: IRS provides tax inflation adjustments for tax year 2021
- IRS.Gov: Questions and Answers on the Net Investment Income Tax
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.