Are Certificates of Deposit (CDs) Tax-Exempt? (2024)

FAQs

Are Certificates of Deposit (CDs) Tax-Exempt? ›

CD interest is subject to income tax in the same year it is credited to your account. Once the money is added, Uncle Sam gets a bite. But you are only taxed on the yield, not the principal. But retirement plan CDs offer exceptions and ways to defer or lower your CD rate taxes.

CD rates may not be high enough to keep pace with inflation when consumer prices rise. Investing money in the stock market could generate much higher returns than CDs. CDs offer less liquidity than savings accounts, money market accounts, or checking accounts.

How to avoid taxes on CD interest. One way to postpone being taxed on CDs is to put them in a tax-deferred individual retirement account (IRA) or 401(k). As long as money placed in a traditional IRA is below the annual contribution limit, interest you earn may be tax deductible.

1. Early withdrawal penalty. One major drawback of a CD is that account holders can't easily access their money if an unanticipated need arises. They typically have to pay a penalty for early withdrawals, which can eat up interest and can even result in the loss of principal.

The Bottom Line. Simply put, yes, the IRS will tax all interest earned on your CD as ordinary income unless the CD is held in a tax-advantaged retirement account. 1 This will be due for each tax year in which the interest is earned.

Are CDs safe if the market crashes? Putting your money in a CD doesn't involve putting your money in the stock market. Instead, it's in a financial institution, like a bank or credit union. So, in the event of a market crash, your CD account will not be impacted or lose value.

Banks and credit unions often charge an early withdrawal penalty for taking funds from a CD ahead of its maturity date. This penalty can be a flat fee or a percentage of the interest earned. In some cases, it could even be all the interest earned, negating your efforts to use a CD for savings.

Ramsey, on the other hand, has described CDs as nothing more than "glorified savings accounts," and says CD returns are typically too low to make the investment worth bothering with. He suggests putting your money into a mutual fund instead of a CD.

The deposit amount won't be prohibitive

But you'll still earn hundreds and possibly thousands of dollars worth of interest with that manageable deposit. For example, a $5,000 deposit into a 5-year CD with a rate of 4.35% (available right now) will result in a $1,186.32 profit upon maturity.

Certificate of deposit (CD)

A certificate of deposit offers a fixed interest rate that's usually higher than what a regular savings account offers. The tradeoff is you agree to keep your money in the CD for a set amount of time, typically three months to five years.

How to avoid paying taxes on interest income? ›

How to Report CD Income on Your Tax Return. Your bank or credit union will issue a 1099-INT statement showing how much interest you earned on your CD account for the year. Include the interest from your 1099-INT on your tax return—Line 2b on your Form 1040.

CDs are commonly taxed the year the interest income is earned and not at maturity, however, an inherited CD and its income accrued before the holder's death are not taxable for the recipient. The only part that's taxable is the interest income from the date of death.

Disadvantages of investing in CDs

Once you decide on the term of the CD, whether it's six months or 18 months, it can't be changed after the account is funded. As noted previously, since CDs have a set interest rate and maturity date, you typically can't withdraw the money from the CD without paying a penalty.

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If interest rates are rising and you lock up your money in a traditional CD for a year or more as rates go higher, you may experience interest rate risk. You're earning less interest than if you had put your money into a traditional CD at a later date.