Certificates of deposit provide you with a low-risk, interest-generating investment option for your money. You can invest your individual retirement arrangement money in a CD, in which case you have to abide by both the terms of the CD agreement and federal tax rules pertaining to IRA withdrawals.
Certificate of Deposit
CDs are illiquid when compared to other savings accounts because you agree for a bank or credit union to lock up your money for a particular period of time. You typically have to pay interest and/or principal penalties if you make withdrawals before the CD matures. At maturity, a seven- to 10-day grace period begins during which you can access your money or make changes to your account. If you opt not to renew the account, then the account custodian normally liquidates the CD and disburses the funds in the form of a check.
Individual retirement arrangements are funded with pretax money. This means disbursements of CD IRA funds are treated as taxable events. Your account custodian reports the disbursement to the Internal Revenue Service and the CD proceeds are added to your taxable income. The custodian does not have to withhold any taxes from your disbursement, but custodians typically withhold 10 percent to go toward your taxes unless instructed not to do so. Aside from paying ordinary income tax on the disbursement, you may also have to pay a 10 percent tax penalty if you have yet to reach the age of 59 1/2.
You can avoid paying both the income tax and the tax penalty if you reinvest your disbursed IRA CD funds into another IRA account. You can buy a CD IRA, add the cash to a brokerage IRA account, set up an IRA mutual fund or even create a self-directed IRA account in which you can hold assets, such as real estate contracts. You must redeposit the CD IRA money within 60 days of the disbursement date. Once this deadline passes the money becomes taxable income and you cannot reverse the disbursement.
IRA disbursements and taxes only become an issue if you liquidate a CD IRA that you bought directly from a bank or credit union. No disbursement occurs if you liquidate a CD IRA that you hold within a brokerage account. When you set up an IRA brokerage account, you deposit cash into a holding account. You can use this cash to buy stocks, bonds, CDs and other securities. The securities remain within the account. When you sell a security or CD matures, the issuing institution liquidates the asset and deposits the cash back into your IRA holding account. Since the IRA money never leaves the holding account, the IRA CD's liquidation remains a non-taxable event.
- Form 1040 Tax Forms image by Viola Joyner from Fotolia.com