A certificate of deposit is one of the safer vehicles on the investment highway. CDs pay market interest rates and return your principal -- the cash you paid for them -- when they mature. The longer the maturity, the higher the rate of interest. Of course, earning interest on any investment or savings account raises a few tax issues.
Banks and CDs
Banks and credit unions offer CDs with various maturities, from 90 days up to several years. You invest cash you want to save, and the CD pays interest, in most cases into a deposit account from which you can make withdrawals. Once the CD matures, you can use the principal for a different investment or roll it over to a new CD.
The Internal Revenue Service taxes any interest you earn on CDs. The institution that issued the CD will send you a 1099-INT form at the start of the year. This tax statement reveals the amount of taxable interest you earned in the previous year; the amount appears in Box 1 of the 1099-INT. The interest on the CD does not have to be paid out to you to be taxable; you must declare the interest as it accrues in whatever amount the 1099-INT reports. You enter taxable interest income on Line 8a and non-taxable interest on Line 8b of Form 1040.
CDs are guaranteed by the Federal Deposit Insurance Corporation (FDIC), which will reimburse you for any losses up to $250,000 per individual account that stem from a bank failure. If you cash out a CD before it matures, however, you may have to pay a penalty. The penalty is reported to you on Form 1099-INT, Box 2. You will still have to report any interest income that you receive, no matter the amount, and add it to your taxable income. You can deduct the penalty in full by entering the amount on Line 30 of Form 1040.
CDs and IRAs
Many savers combine CDs with traditional IRAs, to which you make tax-deductible contributions. If you make CDs part of your IRA, you earn tax-deferred interest income on the CDs until you withdraw the money. Early withdrawals -- made before you reach 59 1/2 -- trigger a penalty as well as income taxes on any income and capital gains earned by the IRA investments. Roth IRAs work differently: you don't deduct contributions but withdrawals are free of income tax.
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