Does Cashing in a CD Count as Income?

Certificates of Deposit (CDs) are a savings tool for individuals seeking a safe investment option with predictable returns. However, cashing in a CD raises questions about whether the proceeds count as income and how they affect tax obligations.

Understanding the tax implications of cashing in a CD is crucial for financial planning and compliance. Here’s a closer look at what constitutes income from a CD and the factors influencing its classification.

Principal vs. Earned Interest

When cashing in a CD, it’s essential to differentiate between the principal and the earned interest. The principal, or the initial deposit, is not considered income upon withdrawal, as it represents the return of the original investment and has no tax implications.

Earned interest, on the other hand, is taxable income in the year it is credited to the account. The IRS requires interest income to be reported on your tax return and taxed at ordinary income rates. For example, if a CD generates $500 in interest over a year, that amount must be reported as income, and the applicable tax rate will depend on your overall taxable income.

Financial institutions typically issue Form 1099-INT to detail the interest earned on a CD. Even if the interest is reinvested or left in the account, it is still classified as taxable income.

Early Withdrawal Penalties

Early withdrawal penalties apply when funds are accessed before the CD reaches maturity. These penalties vary depending on the CD’s term and the institution’s policies. A common penalty involves forfeiting a specific number of months’ worth of interest. For instance, a one-year CD might impose a penalty of three months’ interest. If the CD earns $200 annually, withdrawing early could result in a $50 penalty, reducing the overall return.

Longer-term CDs often have stricter penalties. A five-year CD might incur a six-month interest penalty, significantly affecting the yield. It’s important to review terms carefully and align CD investments with financial timelines to avoid these penalties.

Reporting CD Income

The IRS requires all interest earned from CDs to be reported as income, as documented on Form 1099-INT issued by financial institutions. This form provides a record of the interest accrued during the tax year, which must be included in your federal tax return.

The timing of interest reporting depends on the CD’s terms. For CDs that pay interest annually or at maturity, the interest is reported in the year it is credited. CDs that compound interest more frequently, such as monthly or quarterly, require reporting of the accrued interest for each compounding period. Accurate reporting is essential to avoid discrepancies that could draw IRS scrutiny.

State tax treatment of CD interest may vary. Some states exempt interest earned on CDs from state income tax if the issuing bank is located within the state. Additionally, CDs held within tax-deferred accounts, such as IRAs or Roth IRAs, may allow interest to grow tax-free until withdrawal, depending on the account type. Taxpayers should consult state-specific regulations and consider the benefits of such accounts.

How It Differs from Other Investment Income

CD income differs from other types of investment income, such as dividends from stocks or capital gains from asset sales. CD interest is fixed and predictable, while dividends can fluctuate based on a company’s performance and policies. This variability makes dividend income less predictable and requires a different financial planning approach.

Capital gains, another form of investment income, are taxed differently than CD interest. While CD interest is taxed as ordinary income, long-term capital gains often qualify for lower tax rates, depending on the holding period. This distinction can significantly affect net returns and influence investment decisions. CDs provide stability and security, whereas equities offer potentially higher returns with greater risk and tax complexity.