Purchasing a Certificate of Deposit from a bank is one way to make a low-risk investment with a better yield than a checking or savings account. Just like deposit accounts, CDs earn interest over time until you cash them out at maturity. The amount you pay to buy the CD is generally not taxable, even when you cash it in; however, any interest you earned on the CD before it matured is taxable income, and you'll have to report it to the IRS.
The funds in a CD are only taxable to the extent that they exceed the amount you paid to buy the CD. Any interest you earn on the CD is taxable income. When you pay that tax depends on whether your CD is a long-term or short-term CD. If you cash in a CD early and have to pay a penalty, you may be able to deduct that penalty from your taxes.
What Is a Certificate of Deposit?
A certificate of deposit is a type of investment that accrues interest much like a bank account but at a higher rate. You invest in a CD by purchasing it from a bank and specify how long you want to hold the CD. Most CDs can be held for six months, one year or five years. The date on which that period ends is called the maturity date; when the CD matures, you can either redeem it (cash it in) or renew or extend it. If you choose to cash it in, you get back all the money you invested plus the interest it earned before it matured. CDs are a low-risk investment option, and just like bank accounts, they are federally insured if held at an FDIC-insured bank. The interest you earn on the CD is tax-deferred until the maturity date.
What Happens When a CD Is Redeemed Early?
Because you're supposed to hold the CD for a certain period, you may be penalized if you try to cash it in early. Your CD's terms will vary depending on the type of CD you purchased and the bank, but often, if you withdraw from your CD early, you could be penalized a certain percentage of the balance or a set number of months' worth of interest. For example, if you buy a one-year CD but cash it in after four months, you could have to pay all the interest that would have accrued during the remaining six months as a penalty, which means you would probably lose money on the investment.
CDs Are Generally Not Taxable, but the Interest Earned Is
If you buy a certificate of deposit, you're essentially creating an investment account, like a savings account, where the money will sit for the term of the CD and earn interest without being touched. If you leave the CD alone for the entire term and cash it out when it matures, you'll have earned a certain amount of interest. For example, if you buy a $10,000 CD with a one-year term and interest compounded monthly, and the interest rate is 3 percent, you'll have $10,304.16 at the end of the year when you withdraw it. The withdrawal of $10,304.16 is only taxable income to you, however, to the extent of $304.16, because the other $10,000 was simply what you paid in.
Taxes on Short-Term CDs
A short-term CD is a CD that matures in one year or less. For short-term CDs, you are taxed on interest earned on the CD as of the date you cash it in. So if your $10,000 CD was cashed in for $10,304.16 in 2018, you will include the $304.16 interest earned as income on your 2018 tax return.
Taxes on Long-Term CDs
Long-term CDs are CDs that mature more than one year after purchase, which means that you will accrue interest for a longer period of time before cashing in the CD. Under federal tax law, you cannot allow interest to accrue tax-deferred for longer than one year, which means that if you have a long-term CD, you will have to report the interest income for the tax year even if you did not cash it out. For instance, if you buy a CD for $10,000 but the CD has a two-year term, and interest of $400 accrues during 2018, you'll have to include that $400 as income on your 2018 tax return even though you didn't actually receive it and weren't entitled to receive it.
Taking a Deduction for Early Withdrawal Penalties
If you withdraw the money from your CD before the maturity date and have to pay a penalty, you can take a deduction for the full amount of the early withdrawal penalty, even if the amount is greater than the interest you earned. If you withdraw a one-year CD after only four months and have to pay a penalty of $200, but you earned $100 in interest, you can deduct the full $200 penalty on your taxes.
Interest Earnings Are Taxed as Regular Income
Interest earnings are considered ordinary income for tax purposes and are taxed at ordinary income tax rates. Ordinary income is taxed in brackets depending on your income level and filing status. This is a progressive income tax system; it means that the lower levels of your income are taxed at lower rates, and the rates grow higher as the income increases. Interest income will be added to all your other ordinary income, which will then be taxed according to the appropriate bracket.
2018 Income Tax Brackets for Single Taxpayers
The income tax brackets were changed by the Tax Cuts & Jobs Act, signed into law in December 2017. The tax brackets for 2018 are as follows for an individual taxpayer who is not married or who is married and filing separately:
- You will be taxed 10 percent on all income from $0 to $9,525.
- If your income is more than $9,525, you'll be taxed 12 percent on all income between $9,525 and $38,700.
- If your income is more than $38,700, you'll be taxed 22 percent on all income between $38,700 and $82,500.
- If your income is more than $82,500, you'll be taxed 24 percent on all income between $82,500 and $157,500.
- If your income is more than $157,500, you'll be taxed 32 percent on all income between $157,500 and $200,000.
- If your income is more than $200,000, you'll be taxed 35 percent on all income between $200,000 and $500,000.
- If your income is over $500,000, you'll be taxed 37 percent on all income over $500,000.
The tax for each bracket is added together. So if you're an unmarried person or a married person who files separately, and your total ordinary income, including interest income from the maturity of a CD, is $250,000 for 2018, you'll be taxed progressively:
- $952.50 for the first $9,525 (the 10 percent bracket).
- $3,501 for the next $29,175 (the 12 percent bracket).
- $9,636 for the next $43,800 (the 22 percent bracket).
- $18,000 for the next $75,000 (the 24 percent bracket).
- $10,200 for the next $42,500 (the 32 percent bracket).
- $17,500 for the next $50,000 (the 35 percent bracket) for a total of $59,789.50 in taxes.
This means your top bracket is 35 percent.
Tax Brackets for Married Couples Filing Jointly and Heads of Household
The tax brackets for married couples who file jointly or for individuals who file as head of household are different. Married couples filing jointly have much higher thresholds for each tax bracket; for example, the 35 percent bracket for married couples begins at $400,000. If you're married and you file jointly with your spouse, and your total income together is $250,000, your top tax bracket is only 32 percent. However, the head of household brackets, while more generous for the bottom three brackets, are the same starting with the 24 percent bracket and upward. The $250,000 income would put you into the 35 percent bracket.
- IRS: Tax Topic Number 403 - Interest Received
- IRS: Publication 550 (2017), Investment Income and Expenses
- IRS: Publication 1212 (01/2018), Guide to Original Issue Discount (OID) Instruments
- U.S. Securities & Exchange Commission: Certificates of Deposit (CDs)
- The Tax Foundation: 2018 Tax Brackets
- USA Today: Banking: CD Early Withdrawal Penalties Can Cost You
- CDS - Wikipedia
- Tax Brackets & Rates for Each Income Level (2019-2020)
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D. She has written finance and tax articles for Pocketsense and eHow.