Unless you hold a CD in a retirement account such as an IRA, the interest you earn from CDs will be considered taxable income by the IRS.
This is true for both CDs from banks and from credit unions. At credit unions, the interest from accounts including CDs is often called dividends, but it’s treated the same as interest from a bank. Both the bank and the credit union will send you a Form 1099-INT listing the interest income from the CD.
The amount of interest income that the bank or credit union reports may surprise you. When you’re reviewing your CDs, keep in mind these four tax considerations.
[See: 7 Dividend Stocks to Benefit From Trump Tax Changes.]
Taxes on interest that’s not paid out. First, CD investors may be surprised to see that they owe taxes even when they didn’t receive any direct payments from their CDs. CD investors often open CDs so that the interest from the CD is paid out, either by check or an electronic payment. This interest can be used to supplement a CD investor’s income.
However, if the CD investor doesn’t need extra income, it’s common to open a CD so that interest is added back to the principal of the CD. Whether the CD interest is added back to the CD or paid out, the interest will be taxable. So, even if the bank didn’t send you a check for the interest, you still have to pay income taxes on the interest.
When you owe taxes on interest. Interest from a CD can be paid in any number of fixed intervals, i.e. monthly, quarterly or yearly. If you open a one-year CD that only pays interest at maturity, that interest may only be considered income for the year the CD matured.
This can allow you to defer taxes for up to one year. However, if the one-year CD pays interest monthly or quarterly, you may have taxable interest income for two tax years.
Taxes on interest can’t be deferred for more than one year. It would be nice if you could defer taxes on a long-term CD until it matures. Unfortunately, the IRS does not allow that. According to the IRS Publication 550, “If you buy a CD with a maturity of more than 1 year, you must include in income each year a part of the total interest due.”
[See: 10 Long-Term Investing Strategies That Work.]
Typically, the bank will pay interest in regular fixed intervals of a year or less. If the bank only pays interest at maturity of a CD with a maturity of more than one year, you have to worry about the original issue discount. This is a form of interest that you generally include in your income as it accrues over the term of the CD.
Each year your bank should send you a Form 1099-OID to show you the amount you must include in your income.
Early withdrawal penalty subtraction. Another feature of a CD that can impact your taxes is the early withdrawal penalty. Unlike a savings account, a CD has a maturity date. If you need some or all of the CD principal before the maturity date, the bank will typically allow for an early withdrawal, but only with a penalty. The bank will include both the interest earned for the year and the amount of the penalty as separate items on Form 1099-INT. You can typically deduct the entire penalty, even if it’s more than your interest income.
The case of the early withdrawal penalty being larger than your total interest income can happen for various reasons. First, some CDs have early withdrawal penalties that can be larger than the total interest accrued at the time of the withdrawal. This is common when the early withdrawal is done soon after the CD is opened.
The other reason a penalty may be larger than the interest income is that most of the interest from the CD may have been paid in previous years. For the tax year when an early withdrawal is done and a penalty is incurred, little interest may have accrued.
The interest from CDs can impact taxes a little differently than interest from savings and money market accounts. In one tax year, you may be pleasantly surprised to find that your CD had less interest income than you expected. However, the opposite can happen in other tax years when your CD interest income is more than expected. Understanding how CD interest and penalties are reported can help to eliminate these surprises.
If you have specific questions about your taxes, it’s best to consult a tax professional.
[See: The 10 Best Dividend Stocks of 2016.]
Disclosure: This article contains general information and should not be considered tax advice.
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4 Tax Considerations for CD Investors originally appeared on usnews.com
