How Are CDs Taxed?

A certificate of deposit, also known as a CD, is a fixed income investment offered by banks and credit unions that allows a person to put aside a certain amount of money for a specific period of time at a set interest rate to grow their savings.

Investing in CDs is a good option for someone whose personal finance goals include low-risk investments and the stability of keeping their money safe. Though, as with any income earned on investments, there are tax consequences that come with reporting the income.

During the CD term, interest accrues, and the earned interest is paid when the CD matures. CD interest is counted as taxable income when it is accrued, even though the CD owner cannot access it until the CD matures. The bank will report the amount of CD interest accrued each year to the IRS.

Taxation of Certificate of Deposit Interest Income

Opening a CD is an investment option to grow your money by earning interest income over time. The bank offers specific interest rates on CDs, and customers can earn interest on money held in a CD account for a specific time. During the preset time, the CD earns accrued interest each year the CD remains open.

This interest income earned on the CD becomes taxable income once it is added to your account balance and is due when you file your taxes. The IRS typically taxes any interest income earned above $10 at your ordinary income tax rate. Whether you have your CD in a tax-advantaged account like an IRA or just as a regular CD in a bank will determine when the interest income is taxed.

Tax Brackets

The taxes you pay on interest income from CDs is determined by your ordinary income tax rate, which is based on your income level. It is important to consider which tax bracket you fall under when evaluating the tax implications of CD interest income.

The IRS uses the tax rates it publishes and adjusts annually for inflation to determine your tax rate on CDs. Be mindful that any interest earned on your CD could push you into a higher tax bracket if it’s significant enough.

Here is a list of the tax brackets and income tax rates for CD earnings for the tax year 2023, the taxes you’ll file in 2024.

2023 Tax Brackets and Income Tax Rates for CD Earnings

Exceptions

Although the idea of adding more taxable income to your already taxed income may seem like a disadvantage, there are exceptions to having to pay taxes on the interest income at the CD taxation rates above.

Placing your CD in a tax-advantaged account such as an IRA or a 401(k) can benefit you because you won’t have to pay taxes in the year the CD interest income is earned. You can instead wait to pay the taxes on the money once you retire and withdraw from your IRA or 401(k).

For tax year 2023, the maximum annual amount that you can contribute to an IRA is $6,500 or $7,500 if you are 50 or older, and $22,500 to a 401(k) or similar plan.

Another exception is if you open a jointly held CD where your partner is in a lower tax bracket. This could be favorable as you would owe less tax on the interest income. These exceptions may not apply in all situations, though. State taxes may still apply to interest earned on CDs, even if federal taxes do not.

Long-Term CDs

Typically, CDs with terms longer than one year are considered long-term CDs and are taxed differently. Each year of the CD term that interest is earned, you must pay taxes on any interest in that year.

Let’s say, you have a five-year CD, and you earned $50 in interest during the first year of the term. You’ll receive a 1099-INT Form and have to report the $50 in interest on your tax return.

Then, in the second year, you earn another $50 in interest income. You will also have to report this on your tax return and any other interest income earned in each of the remaining three years of the CD term.

These rules could also apply to a short-term CD that was bought late in the year. If the CD’s term spans two calendar years, then the tax burden of that CD could still be split between two tax returns.

Most CDs are structured as zero-coupon instruments. With such a vehicle, the money saved and the interest accrued is not accessible until maturity. However, accrued interest is periodically applied to your account – and as it is applied, it is taxable. So, even though you do not receive any interest until maturity, you will be taxed throughout the CD term.

Thomas J. Brock, CFA®, CPAInvestment, Corporate Finance and Accounting Professional

Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.

Tax Implications of Inheriting a CD

There are tax implications of inheriting a CD. Factors like estate taxes, RMDs, and whether or not the original holder had already paid income taxes can all affect the new owner.

Generally, when a CD is inherited by a beneficiary, the value of the CD is not taxable to the beneficiary for federal tax purposes. Inheritances are not considered income based on the standard IRS rules. This includes the deposit amount and interest earned through the date of death. However, any interest earned on the CD after the date of death counts as income to the beneficiary and would be taxable.

Federal estate taxes may apply to assets of a deceased person worth more than $12.92 million as of 2023.

Whether the inherited CD is taxed at the state level depends on which state the beneficiary resides in. Currently 12 states and Washington, D.C., impose estate taxes, whereas six states impose an inheritance tax.

The tax implications of inheriting a CD can be complex and may vary depending on your specific situation. It’s a good idea to consult with a tax professional to determine your specific tax obligations related to inheriting a CD.

Early Withdrawal Penalties and Taxation

When you open a CD at your bank, you agree to a set term in which to keep your money in the CD to earn interest.

Typically, you can choose from a set term of three months, six months, nine months, one year, 18 months, three years, or even as long as five to 10 years.

However, if you decide to withdraw from your CD early before it reaches the set term, you may have to pay early withdrawal penalties and forfeit some of the interest on your account.

Each bank has its own policy on the amount of interest penalty charged based on the CD type term. Below is an example of typical early withdrawal penalties.

The good news is the IRS allows you to deduct the full amount of the early withdrawal penalty on your tax return even if the penalty is more than your interest income.

The early withdrawal penalty amount will be shown in box 2 of Form 1099-INT. This amount is reported on your tax return on Schedule 1, Part II of Form 1040 as adjustments to income on line 18, penalty on early withdrawal of savings as of tax year 2022.

Reporting Your CD Income

Any interest that you earn of $10 or more on CDs must be reported to the IRS when you file your tax return, even if you don’t receive a 1099-INT.

Let’s say, you receive Form 1099-INT from your bank. It’s $15 of interest income. You will have to report this income since it counts as taxable income.

The amount of interest income will be shown in box 1 of the 1099-INT form. This amount will need to be reported on Schedule B and line 2b of your Form 1040 as taxable interest. Tax-exempt interest is reported on line 2a of the 1040.

Aside from opting to withdraw from your CD early to have the penalties as a tax deduction, there are ways to reduce the tax burden.

Avoid locking all your money in a CD by making sure you keep enough available money in your checking or savings account to cover your tax liability. Also setting up a CD ladder by putting cash into multiple CDs with different maturity dates will allow you to have available cash when it’s time to pay the tax on CD income.

Form 1099-INT

Form 1099-INT is an IRS tax form that reports taxpayer interest income and expenses for a tax year. Your financial institution will typically send this form at the beginning of the year.

It details your interest income earned in the prior year. It includes information regarding interest income, early withdrawal penalty, interest on U.S. Savings Bonds and Treasury obligations, tax-exempt interest, foreign tax paid, federal and state income tax withheld, investment expenses, market discount, and bond premium.

This form is used to report interest income on your tax return.