How are CDs taxed? How to minimize your tax bill

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Certificates of deposit (CDs) are popular savings accounts that guarantee a fixed rate of return over a set period. They’re offered by banks and credit unions to consumers looking for a low-risk way to earn interest on their money. 

But when tax time rolls around, you will face taxes on the interest you earn on your CD. Here’s everything you need to know about how CD interest is taxed and how to optimize your returns.

Are CDs taxable? 

Yes, the IRS considers the interest earned on CDs taxable income. Like with savings accounts and money market accounts, you must report the interest your CDs earn each year. 

If you earned over $10 in interest in a year, you must report it on your taxes. The interest is subject to federal income tax, as well as state and local taxes in most areas. 

You will owe these taxes in the year that you were paid the interest, even if your CD has yet to reach its maturity date. 

CDs differ from tax-advantaged accounts, like 401(k)s or IRAs, which defer taxes on the interest you earn until you withdraw the money. Deferring gives your money more opportunity to compound before being subject to taxation.

You can hold a CD in your IRA to qualify for tax deferment, but your CD must play by IRA withdrawal rules. This means that even after your CD matures, you must wait until retirement to withdraw your money without penalty. 

How CDs work 

CDs are deposit accounts with your bank, credit union, or other financial institution. You agree to lock up your money for a set period, anywhere from three months to five years. The issuer agrees to pay you a fixed interest rate. 

After the CD matures, the issuer will return your original investment plus interest earned. Withdrawing funds before maturity can result in hefty penalties, especially with longer-term CDs. 

“2023 was a record year for individual bond and CD sales,” says Sam Millette, director of fixed income at Commonwealth Financial Network. “[Our] trade desk processed nearly seven times more individual fixed income trades in 2023 compared to 2021.” 

This “increased appetite,” as Millette puts it, may be caused by current high CD rates. Top CDs offer rates above 5%, higher than some high-yield savings accounts or money market accounts. 

CDs are often viewed as low-risk investments because they offer fixed rates and are FDIC insured. Some investors may enjoy earning stable interest, especially during economic uncertainty. 

How CD interest income is taxed 

Interest earned on CDs counts as ordinary taxable income, just like wages. It’s subject to your federal income tax rate and must be reported each year. 

Your 2024 federal income tax bracket depends on your annual gross income and filing status. Ordinary tax rates range from 10%-37%. 

So, if you’re in the 22% tax bracket and earned $100 of interest on a CD, you’d pay $22 in federal taxes. 

In addition, most states and some cities tax interest income. State income tax rates range from 0% to over 13%, depending on your state. 

Some local municipalities like New York City also impose taxes. State and local taxes can notably increase your overall tax bill on CD earnings. Those residing in high-tax areas may want to run the numbers to see if CD returns will be worthwhile after taxes.

How to report CD income on your taxes

Banks will mail you Form 1099-INT by January 31st, reporting the previous year’s interest. You then include that number on your tax return. 

Even if your bank does not mail a 1099-INT, you must still report your interest income to the IRS. 

Failure to report interest can result in penalties, fees, liens, and audits. The IRS receives copies of all 1099-INT documents to cross-check the total interest reported against your return. 

How to avoid taxes on CDs 

While you can't completely avoid paying taxes on CDs, there are some ways to help you manage your liability more effectively.

Contribute to retirement accounts like IRA or 401(k)

If avoiding taxes is your top priority, you’re probably better off focusing on your 401(k) and IRA accounts. These accounts are tax-deferred until retirement. 

You can hold a CD in a traditional IRA, known as an IRA CD. This converts your earnings into tax-deferred growth rather than immediately taxable income. 

Using retirement accounts is one of the most effective ways to avoid CD taxes. The tradeoff is surrendering some liquidity, as you often can’t withdraw your money penalty-free until you reach a certain age. But as a long-term savings option, IRA CDs are advantageous.

Invest in a shorter-term CD

Taxes are based on a full calendar year of income, including interest earned. You then typically report your taxes to the IRS by April 15th of the following year. Knowing the tax season schedule can help you play timing games around CD maturity dates. 

You can purchase a 1-year CD at the beginning of the year (before April) and redeem it before taxes are due next year. Doing this lets you pay your tax bill with the interest earned on your CD. If your CD matures before April 15, you may need to use your checking or savings account money to pay your taxes. 

Remember, you still end up paying the same taxes with this strategy. But it does help manage your finances during tax season.

Try CD laddering

Another way to pay your taxes with interest earned is CD laddering. This involves splitting your money into several CDs simultaneously, with staggered maturity dates (like three months, six months, nine months, and so on). 

When each CD matures, you roll it into a new 12-month CD. This provides consistent liquidity while maximizing the amount kept in the short term. The result is compounding interest while minimizing taxes year after year. 

By doing this, Millette says, “an investor can generate current income while potentially lowering the impact of interest rate fluctuations on their long-term returns.”

Don't automatically reinvest interest payments

The principal balance grows when you reinvest interest payments into the CD. This will inherently increase future interest returns. That sounds great, but you may end up in a higher tax bracket because of it. 

Putting interest earned from a CD into a tax-deferred account, such as an IRA, can help your money grow without raising your annual taxable income. 

What to consider when opening a CD 

There are many different types of CDs, so it’s essential to know what you’re looking for before opening a CD: 

• Interest rates: Compare CD rates to other options like high-yield savings accounts. 
• Term lengths: CDs come in various lengths, ranging from a few months to several years. You may want to stick with shorter terms if you need the money soon. If you don’t need access to the money and are looking for a safe investment, you can explore longer-term CDs. 
• Early withdrawal penalties: A CD is an agreement with the bank. Failing to fulfill your obligations can result in significant penalties. Review the early withdrawal policies in the terms and conditions of the CD before buying. 
• Minimum deposits: Some CDs require a minimum deposit, especially to qualify for higher interest rates. But plenty of CDs are available that do not have this requirement. 
• Taxes: Run the numbers to see if the potential taxes on the CD’s interest are worth it. 
• Insurance: You want to ensure your bank CD is FDIC insured up to a $250,000 limit. This protects you if the financial institution fails. 

The bottom line 

CDs have recently regained some popularity due to rising interest rates. However, paying taxes on the interest may make them less appealing than tax-deferred accounts. 

Luckily, investing is not an all-or-nothing game. Your portfolio should have diverse investments to lower your overall risk and maximize your gains. It’s best to talk to your financial advisor or tax expert to learn how CDs might help you achieve your goals.

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