When and How to Pay Taxes on Your CD Interest Earnings
Having to pay taxes on interest that you earn probably comes as no surprise.
What may come as a shock is that, with some Certificates of Deposit (CDs), you may have to pay taxes before you can even get your hands on that interest.
Knowing when the tax on a CD is due and planning how to pay it are essential steps to avoid tax penalties or early withdrawal penalties.
This article explains when taxes on a CD are due and how you can prepare to pay those taxes.
Taxes on CDs in IRAs
If you own a CD in an IRA, you won’t have to pay tax on it from year to year, even though that CD is steadily earning interest.
Think of your IRA as a protective shell around your money. No matter what goes on inside that shell – interest being earned, securities being bought and sold, CDs maturing or being rolled over, etc. – there are no tax consequences as long as the money does not leave the IRA.
Holding a CD in an IRA should exempt the interest from taxation until you start withdrawing from the IRA.
Just make sure that, when the CD matures, the proceeds are placed into an IRA account and that the issuer of the CD is notified of this. That will prevent those proceeds from being considered a distribution from the IRA and thus subject to taxation and possible penalties.
Traditional IRAs at age 70 1/2: required minimum distributions
The one tax twist about owning CDs inside an IRA comes into play if you have a traditional IRA and reach age 70 1/2. At that point, you must start taking the required minimum distributions (RMDs).
To meet this requirement, you must ensure you have money available to withdraw from the IRA. This can be an issue if the IRA is invested entirely in long-term CDs.
For example, let’s say that when you reach age 70 1/2, your entire IRA is invested in a long-term CD that won’t mature for a couple of years. In that case, you may choose between paying an early withdrawal penalty to break into the CD before it’s set to mature or suffering the tax consequences of failing to make an RMD.
As you approach retirement age, structure the CDs in your IRA to mature on time to provide enough money to meet your minimum distribution requirements.
Note that RMDs apply only to traditional IRAs and not to Roth IRAs.
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Taxable Income on CDs
Now, suppose you own a CD in a taxable account – that is, not within the protective shell of an IRA.
In that case, you have to pay tax on the CD interest for the year in which that interest is earned. The tricky part is that CDs make interest throughout their terms and not just when they mature.
For example, if you own a five-year CD, interest will be credited to your account each year. If that interest is reinvested directly into the CD, you will owe taxes long before you finally get your hands on the money at the end of five years.
This surprises some people because they do not expect to have to pay taxes on money that hasn’t yet been delivered to them. However, your bank should send you a Form 1099-INT each year notifying you of the amount of earned interest you owe taxes on that year.
How to Pay Taxes on Multi-year CDs
If you have a significant amount of your savings invested in a multi-year CD, how can you plan to have money available to pay taxes on the interest it earns from year to year?
You have a few good options:
Use outside savings to pay the tax
This may be the easiest solution if you have enough savings outside of your CD to pay the tax.
In most cases, you won’t have to pay taxes till after year-end, so you can allow savings to accumulate outside your CD throughout the year and then draw from that to pay the tax due on your CD interest.
Choose a CD that makes regular interest distributions
Some CDs give you a choice when you sign up: Interest earned can be reinvested in the CD or distributed to you at regular intervals.
While reinvesting in the CD is the most efficient way to compound your interest, having the interest distributed to you may be a convenient way to ensure you have cash on hand to pay the taxes on that interest. Just be sure to make this choice when you sign up because the default option is often to have interest reinvested in the CD.
Set up a CD ladder
A CD ladder is a series of CDs optimized with different maturity dates so that you can get the benefit of long-term CD yields while also getting liquidity at regular intervals. If you set it up so that a CD matures near the end of each year, you will have a timely source of cash to make tax payments.
Preparing to Pay Taxes when Rolling Over a CD
Even if you use short-term rather than multi-year CDs, you should plan to make sure you have cash available to pay taxes on the interest.
As you plan how much cash to make available for taxes, remember to allocate some money to pay state taxes (if your state has an income tax) on your CD interest and federal taxes.
Upcoming tax needs should be remembered when rolling over a maturing CD into a new one.
Banks make it easy for you to roll the proceeds of a maturing CD directly into a new CD, but before you automatically roll over the total proceeds, keep your upcoming tax payments in mind.
Unless you have another source of cash, you may want to hold back some of the proceeds from your maturing CDs to pay taxes on the interest those CDs earned. Then, you can simply roll the proceeds into a new CD.
Next Steps: Preparing to Pay Taxes on a CD
Whether you own CDs in an ordinary taxable account or an IRA, you should choose your CDs with future tax needs in mind.
Here are some steps to make this happen:
1. Make a schedule of the timing and amounts of taxes on your CD
To estimate the annual tax obligation on your CD interest, use this formula:
$ value of the CD x CD interest rate x your income tax rate = annual tax obligation
If you have CDs in a traditional IRA and have reached an age where you must make RMDs, your planning involves two parts:
First, calculate the amount of the RMD you will have to make that year.
Second, calculate what the income tax on that RMD will be.
These two parts have different purposes. The amount of the RMD must be removed from the IRA, but it can be rolled over into a taxable CD outside of the RMD.
However, the tax on the RMD will have to be paid, so you may need to set aside some cash to pay that tax when the time comes.
2. Set up the timing of CD maturity dates with your tax schedule in mind
Based on the scheduled timing and amounts of your tax payments and RMDs, set up your CDs so that the required amounts will be in CDs mature enough to make those payments.
The best way to do this may be by setting up a CD ladder.
This involves having a series of CDs with different maturity dates. That way, you can have some cash available at regular intervals while having a portion of your money invested in longer-term CDs at higher rates.
For most people, this may mean having one CD mature each year in an amount large enough to make the tax and RMD payments for that year.
If your tax situation is such that you’re required to make quarterly estimated tax payments, you could set up your CD ladder to have a CD maturing each quarter to make those payments.
Alternatively, you could arrange to have enough cash outside your CDs to meet your tax obligations. However, since CD interest rates are generally higher than savings account rates, you could earn more by arranging the timing of your CD maturity dates to match up with the timing of your tax obligations.
3. Shop for the best CD rates
Once you know which CD maturity dates you need, compare banks to find the best rates.
Every time one of those CDs matures, any portion that isn’t needed to meet tax obligations could be rolled over into a new CD. Since CD rates change all the time, you should check rates each time this happens.
Too often, people simply allow their CDs to roll over automatically without checking to see if they’re getting a competitive CD rate. Settling for less than the best CD rates could mean earning a fraction of the interest available.
4. Consider an online bank
Because of their cost advantages, online banks often offer the best interest rates. Since a CD doesn’t require any decisions between the day it is created and when it matures, you don’t need the branch-based service of a traditional bank anyway.
How to Ladder an IRA CD Without Taxes or Penalties
CDs benefit from safety and predictability, which may be desirable if you are nearing retirement age and expect to draw from your CD soon. However, if you have several years until retirement or otherwise don’t need to make significant withdrawals from your IRA for the foreseeable future, growth instruments may be more appropriate investments.
The time frame of when you anticipate drawing from your IRA is significant for two reasons:
- A shorter time frame may dictate when investments need to provide liquidity.
- A longer time frame may make inflation more of a concern.
The shorter time frame would make investments like CDs more appropriate, while the longer time frame may suggest mixing in some growth investments like stocks.
What do you gain by laddering?
CD laddering can be a valuable technique to manage cash flow or hedge against interest rate changes. However, if you have a few years before worrying about liquidity, you might be better off with the higher rates offered by long-term CDs.
The ideal situation is when you are still contributing annually to the IRA. If you buy a new long-term CD each year, that naturally creates a CD ladder, which will eventually start to mature at regular intervals — but you will still benefit from higher long-term CD rates.
Where are the best CD rates?
Speaking of CD rates, before you restructure your CD holdings at your current bank, look to see if that bank is offering fully competitive CD rates.
On the MoneyRates CD rates page, the best rates across various maturities pay over 1% more than the national averages. Rates are updated every week, so look at that page before you settle for what your bank is offering.
