Certificates of deposit are special types of savings accounts typically issued by banks that promise to pay a higher rate of interest than what is usually available on a regular savings account in exchange for a promise that you will leave the money on deposit for a certain period. This time frame ranges from three months to five years, but it can be any term the bank and depositor agree to. CDs issued through banks are insured by the Federal Deposit Insurance Corp. up to $250,000. Whether a CD investment can be subject to income tax depends on a few considerations.
CDs as a Taxable Investment
Outside of any tax-advantaged situation, such as a retirement arrangement, interest income from a CD is taxable. It is also taxable at your nominal tax rate as regular income and not as a capital gain. For example, if you are in the 25 percent tax bracket and you earned $250 on a certificate of deposit for the year, you will owe $62.50 in taxes.
You can defer the taxes on a CD investment by opening it inside a pre-tax retirement arrangement, such as a traditional individual retirement account. With these accounts, you can also take a tax deduction for your contribution for the year. Qualifying people under age 50 can contribute up to $5,000 in an IRA each year as of 2012. The interest is added to the account each compounding period, and you do not pay any taxes on the money until you withdraw it at retirement age. If you need to withdraw it earlier, you will pay a 10 percent tax penalty plus taxes on the amount you withdraw, plus any penalties for early withdrawals on the CD.
A Roth IRA offers different tax benefits than a traditional IRA. While you receive no immediate tax benefit for your contributions, the interest grows tax-free and remains tax-free when you withdraw it at retirement age. You can also withdraw your contributions at any time without tax penalty, but you will have to pay a penalty to your bank if you withdraw any of the principal before the CD matures.
When Taxes Are Due
Your bank will pay you the interest periodically on your CD. The taxes are due on taxable interest in the year the bank pays it to you. The interest is reported on Form 1099-INT, in Box 1. If you have to pay a penalty for early withdrawal, it will be shown in Box 2 on the Form 1099-INT. Report the interest on line 8A of your form 1040, and deduct any penalties on line 30, even if the penalty is higher than the interest you paid.
- U.S. Securities and Exchange Commission: High-Yield CDs –- Protect Your Money by Checking the Fine Print
- Bankrate: When Is a CDs Interest Taxed
- IRS.gov: Publication 550 -- Investment Income and Expenses
- Bankrate: Interest and Penalty on a CD
- CNN Money: What's the Difference Between Roth and Traditional IRAs?
- bank image by Pefkos from Fotolia.com