How to Avoid Tax on CD Interest: Strategies to Reduce Your Tax Burden

Certificates of Deposit (CDs) offer a secure way to earn interest on savings, but tax implications can reduce potential gains. Understanding how CD interest is taxed and employing strategies to minimize this burden is essential for maximizing returns.

Criteria Determining CD Interest Taxation

The taxation of CD interest is influenced by several factors. Interest earned from CDs is considered ordinary income and is subject to federal income tax, with rates ranging from 10% to 37% under the 2024 tax brackets. Higher-income individuals may face a greater tax burden.

State taxes also play a role. States like Florida and Texas do not impose state income tax, while others, such as California, can tax CD interest at rates up to 13.3%. Knowing your state’s tax policies is crucial for calculating total tax liability.

Timing also matters. The IRS requires taxpayers to report interest income in the year it is credited, even if the CD has not matured. This means taxes may be due on interest that has not been withdrawn, potentially impacting cash flow.

Offsetting Interest With Capital Losses

Using capital losses to offset CD interest income is a useful tax strategy. Losses from investments like stocks or bonds can reduce taxable interest income. If losses exceed gains, up to $3,000 of the remaining losses can offset other income, including CD interest, annually.

For instance, if an investor earns $5,000 in CD interest but has $4,000 in capital losses, they can reduce their taxable interest to $1,000. This can lead to significant tax savings, particularly for those in higher tax brackets. Unused capital losses can be carried forward to future years for continued tax benefits.

Proper documentation of capital losses is essential, and investors must comply with the IRS’s “wash sale” rule, which prohibits claiming a loss on a security repurchased within 30 days of being sold. Adhering to these rules helps avoid penalties.

Holding CDs in Certain Accounts

Holding CDs in tax-advantaged accounts can reduce the tax burden on interest income. Traditional and Roth Individual Retirement Accounts (IRAs) are effective options. CDs in traditional IRAs grow tax-deferred, with taxes due only upon withdrawal, often during retirement when tax rates may be lower.

Roth IRAs, on the other hand, allow for tax-free qualified withdrawals, including interest income, since contributions are made with after-tax dollars. This can be especially beneficial for younger investors who expect higher tax rates in the future.

Health Savings Accounts (HSAs) also provide tax advantages. Interest income in HSAs grows tax-free if used for qualified medical expenses. The combination of tax-deductible contributions, tax-free growth, and tax-free withdrawals makes HSAs an attractive option for holding CDs, especially for individuals with high-deductible health plans.

Filing Status Variations

Filing status affects how CD interest is taxed. The IRS recognizes five filing statuses: single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with a dependent child. Each has unique tax brackets, standard deductions, and eligibility for credits or deductions that influence tax liability.

Married couples filing jointly often benefit from wider tax brackets and a higher standard deduction, potentially lowering their effective tax rate on CD interest. Conversely, those filing separately may lose access to certain tax credits, such as the Earned Income Tax Credit.

The head of household status offers a higher standard deduction and more favorable tax brackets compared to filing as single. This can be advantageous for single parents or those supporting dependents, as it reduces taxable income and the overall tax burden on CD interest.

Reporting Requirements

Accurate reporting of CD interest is essential for tax compliance. Interest income must be reported annually, even if not withdrawn or reinvested. Financial institutions issue Form 1099-INT to account holders who earn more than $10 in interest during a tax year. This form details the interest earned and must be included on the taxpayer’s Form 1040.

Even if interest earned is less than $10 and no Form 1099-INT is received, taxpayers are still required to report the income. The IRS cross-checks Forms 1099-INT against tax returns, making accurate reporting critical. Interest that compounds but is not withdrawn during the tax year must still be reported, as the IRS considers it constructively received.

For joint CD accounts, interest must be reported proportionally based on ownership. For example, if a jointly held CD earns $1,000 in interest, each owner must report their share on their tax returns. Clear documentation and communication with financial institutions can simplify reporting, particularly for joint accounts or multiple CDs across institutions.