When you own a regular certificate of deposit (CD), you owe income tax on your interest every year. By investing through an Individual Retirement Account (IRA) CD instead, you can delay or even completely avoid taxation on this income. The exact tax result depends on the type of IRA you use and when you take money out of your account.
As long as you keep your CD interest in your IRA, you won't owe income tax. This applies to both the Roth and the traditional IRA. When you earn interest income, You can use the money to buy another CD or invest in any other asset. Either way, you still get to delay income tax on the income. This is a significant advantage over a regular CD because with this account, you owe taxes on your interest that tax year, even if you reinvest the money right back into another CD.
The amount of tax you'll owe on your IRA CD interest partly depends on when you take the money out. You'll owe the least amount of tax if you wait until the IRA retirement age, which is 59 1/2. If you are using a traditional IRA CD, you'll owe income tax on your interest income when you take it out at retirement. If you are using a Roth IRA CD, your withdrawals are tax-free during retirement. That means with the Roth IRA, you'll never owe income tax on your interest income in retirement.
If you want to take out your IRA CD interest before you turn 59 1/2, you are making an early withdrawal. The IRS charges income tax plus a 10 percent penalty on early withdrawals from an IRA. This applies to all withdrawals from a traditional IRA and the early withdrawal of investment income from a Roth IRA. Because CD interest is investment income, that means you'll owe the 10 percent penalty for taking out your interest income early from either type of account.
There are a few situations when you can take out your interest income early and avoid the penalty. If you become permanently disabled, you can take your interest income out penalty-free. You can also use your IRA CD interest to pay off medical bills that exceed 7.5 percent of your adjusted gross income. If you are buying your first home, you can use $10,000 of interest income without owing the penalty. Lastly, you can use your interest income to pay off college expenses for either yourself or a family member. While these situations avoid the 10 percent penalty, the IRS still charges income tax on these withdrawals.
Dylan Armstrong specializes in insurance, investing and retirement planning. He has also worked as a life and health insurance salesman and holds a Bachelor of Science in finance from Boston College.