Certificates of deposit offer the security of a fixed interest rate and, if you get the CD from an FDIC-insured bank, protection for the money even if the financial institution goes bankrupt. However, before you sign your name on the dotted line, you need to understand when the interest is taxable.
Interest Is Taxable
The interest on a certificate of deposit counts as taxable income, but the principal that you receive back when you cash out is tax-free. For example, if you invest $1,000 in a six-month CD and you cash out $1,030 at the end of the term, you only have to pay income taxes on the $30, not the entire distribution. To document the interest you receive, your bank sends you a Form 1099-INT that include the amount of interest paid for the year in box 1.
Year to Report
Generally, you must report the interest from the CD in the year the interest gets deposited in your account, whether or not you cash in the CD. For example, if you invest in a five-year CD that pays interest annually, you must report the interest as taxable income in each of the five years, because having the money deposited in the CD account counts as you receiving the money. Likewise, if you have a CD that will only pay you the interest when the CD matures in three months, you can't delay the taxes by not cashing in the CD until the next year.
Deduction for Early Withdrawal Penalties
If you cash out your CD early, your bank likely charges you a hefty early withdrawal penalty. This penalty is reported in box 2 of your Form 1099-INT. On the bright side, the IRS gives you a tax break for this penalty by allowing your to deduct the penalty. Because the IRS classifies the deduction as as an adjustment to income, you can still take the write-off even if you don't itemize your deductions.
When you file your taxes, you must include the interest as part of your taxable income. If you have less than $1,500 in taxable interest for the year, you can file your taxes using Form 1040EZ, Form 1040A or Form 1040. However, if you have more than $1,500, you have to complete Schedule B and use either Form 1040A or Form 1040. If you have an early withdrawal penalty, do not subtract it from your interest income. Instead, report it as an adjustment to income on line 30 of Form 1040.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."