Income Taxes on CDs

Many people like the predictable return that certificates of deposit, also called CDs or time deposits, offer and the fact that they often pay slightly more interest than savings and money market accounts. The IRS taxes this interest earned on CDs as ordinary income. In addition to interest, ordinary income includes salaries/wages, royalties, commissions and short-term capital gains on investments.

Interest on CDs in tax-deferred accounts (e.g., traditional IRAs) is taxed when distributions are made, typically in retirement. Required minimum distributions (RMDs) from tax-deferred accounts must begin at age 73 for people born from 1951 to 1959 and at age 75 for those born in 1960 or later.

For CDs with maturities longer than a year (e.g., five-year CD), taxes are due on interest earned each year, even if this money is not received until the CD matures or is rolled over into a new CD. Financial institutions where CDs are held report interest on Form 1099-INT. The interest amount is then reported to the IRS using Schedule B, Part I.

If a CD matures in the same calendar year as its purchase date, the math is very simple. All the interest earned during its short term (for example, three, six or nine months) is taxable that year.

For multi-year CDs, taxes are typically due each year for the amount of interest credited to the CD. For example, in the first year of a 5-year CD, taxes are due on interest earned during that calendar year. The same is true for years two, three, four and five.

Owners of multi-year CDs in taxable accounts, therefore, pay taxes on interest they will not receive until a CD matures. Some people are not happy to pay taxes on “phantom money.” On the plus side, taxable income is spread over several tax years instead of bunched into one. This can reduce the amount of tax owed.

Many multi-year CD owners use a laddering strategy. Instead of purchasing one CD with one fixed maturity date, they divide their cash among several CDs with varying maturity dates. When CDs mature, the money gets reinvested in new CDs with the same term as the longest CD in the original ladder.

Read More: What Is a CD Ladder?

CD interest shown on Form 1099-INT gets tallied along with interest from other sources like checking, savings and money market accounts. 1099-INT forms from financial institutions typically arrive by Jan. 31 of the following year and provide a summary of interest paid on CDs throughout the previous tax year. All taxable interest must be reported even if a 1099-INT form is never received.

With CD interest rates significantly higher in 2023 than they were a few years earlier, tax withholding should be reviewed and, perhaps, adjusted upward. For example, an older adult earning 2% on a $200,000 CD may have earned $4,000 in annual interest in 2021. In 2023, with 4.5% interest, a similar CD could be earning $9,000. That is a $5,000 increase in annual taxable income.

Use the IRS tax withholding estimator tool or consult a tax advisor to determine the correct withholding on all income sources to avoid an under-withholding penalty.

CD interest is entered on Schedule B, Part I, and total interest income from all sources is transferred to Form 1040, Line 2b. From there, it becomes part of the calculation of a taxpayer’s total income and, ultimately, adjusted gross income (AGI) and taxable income. If the total amount of taxable interest and/or ordinary dividends reported on Schedule B is over $1,500, additional questions must be answered on that form.

Once taxable income is calculated and tax credits are subtracted from this amount, tax withholding or estimated payments are compared to tax due to determine a refund or amount owed.

Tax rules on inherited CDs depend upon whether they are held in taxable or tax-deferred accounts, like CDs in traditional IRAs. A deceased person’s will (or state intestacy laws without a will) determines the beneficiary of CDs in a taxable account. Since inherited money is not considered income by the IRS, CD values are not taxed by the IRS. Any CD interest subsequently earned by the beneficiary, however, is taxable.

With CDs held in traditional IRAs, where no tax was previously paid on deposited cash or earnings, IRS rules for beneficiary RMD distributions apply. Surviving spouses can roll inherited IRAs containing CDs (or any other investment) into their own account and take RMDs based on their own age. Most non-spouse beneficiaries must take distributions from the deceased person’s IRA over 10 years and liquidate retirement accounts by Dec. 31 of the tenth year after the original owner’s death.

Seek assistance from a financial advisor for RMD-related questions.

CD owners must forfeit some earned interest if they break — meaning cash out — a CD prior to its maturity. Financial institutions charge penalties to encourage depositors to keep CDs for their full terms. 

Early withdrawal penalties on CDs can be deducted on federal income tax returns, even if they are greater than earned interest. The penalty amount is shown on Form 1099-INT (Box 2) and is reported on Schedule 1, Line 18, “Penalty on Early Withdrawal of Savings.”

To reduce income taxes on interest earned on CDs, consider the following strategies: postpone or eliminate taxes, stagger interest payments and tax planning techniques.

Money placed in a CD within a traditional IRA is generally tax-deductible (limits may apply for high earners) in the year that it is contributed and taxes on contributions and earnings are not taxed until withdrawn.

Roth IRA contributions placed in CDs are made with after-tax dollars. Therefore, contributions are not deductible on your taxes, but earnings are tax-free.

By laddering CDs, small amounts of taxable interest are earned on multiple CDs that mature in different tax years versus owing tax on interest from one large denomination CD in one tax year.

Strategies to reduce taxes and indirectly offset taxable CD interest include: