How Is Interest on a CD Taxed? A Simple Breakdown

A Certificate of Deposit (CD) is a savings account that holds a fixed amount of money for a fixed period, and in return, the issuing bank pays interest. While CDs are generally considered low-risk investments, their earnings are subject to specific tax rules that investors should be aware of.

Understanding Taxable CD Interest

Interest earned on Certificates of Deposit is generally considered taxable income at the federal level and is subject to ordinary income tax rates, similar to wages or salary. This applies whether the interest is paid out to you or reinvested back into the CD. The tax obligation arises in the year the interest is earned or accrued, not necessarily when the CD matures or the interest is finally paid out.

For CDs with terms longer than one year, interest is often taxed annually, even if you do not receive the funds until maturity. This is due to Original Issue Discount (OID) rules. OID applies when a debt instrument, like certain CDs, is issued at a discount from its stated redemption price at maturity. The discount is essentially treated as interest that accrues over the life of the CD and must be reported as income each year.

Reporting CD Interest on Your Taxes

Financial institutions are required to report interest earned on your CDs to the IRS. If you earn $10 or more in interest from a CD during a tax year, the financial institution will issue Form 1099-INT, Interest Income, by January 31 of the following year. This form details the amount of interest you earned, typically in Box 1. Form 1099-INT also includes other relevant information, such as any early withdrawal penalties in Box 2.

You must use the information provided on Form 1099-INT to report your CD interest income on your federal tax return. If your total interest income for the year exceeds $1,500, you will generally need to file Schedule B, Interest and Ordinary Dividends, along with your Form 1040. Even if you do not receive a Form 1099-INT, you are still obligated to report all interest income earned.

Key Tax Considerations for CDs

If you withdraw funds from a CD before its maturity date, you may incur an early withdrawal penalty. This penalty can often be deducted from your gross income, potentially reducing your overall taxable income. This deduction is taken as an adjustment to income on Schedule 1 of Form 1040, rather than as an itemized deduction.

CD interest may also be subject to state and local income taxes, in addition to federal taxes. The rules and rates for state and local taxation vary significantly by jurisdiction, so it is important to understand the regulations in your specific area. Some states may not tax interest income, while others will tax it at varying rates.

CDs held within tax-advantaged accounts, such as Individual Retirement Arrangements (IRAs) or 401(k)s, are treated differently for tax purposes. Interest earned on CDs within these accounts grows tax-deferred or tax-free, depending on the account type. For example, with a traditional IRA CD, taxes on the interest are deferred until you withdraw the funds, typically in retirement. In a Roth IRA CD, contributions are made with after-tax dollars, and qualified withdrawals, including interest, are tax-free. This deferral or exemption from annual taxation can provide a significant advantage for long-term savings goals.