When Is Tax on A CD Due?
Having to pay taxes on interest that you earn probably comes as no surprise.
What may come as a bit of 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 tax on a CD is due and planning for how to pay it are essential steps if you want 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 with regard to 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 required minimum distributions (RMDs).
In order to meet this requirement you must make sure that 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 years. In that case, you may face a choice 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, begin to structure the CDs in your IRA so that they will 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 about that is that CDs earn 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 in each of those five years. If that interest is reinvested directly into the CD, you will owe taxes on it long before you finally get your hands on the money at the end of five years.
This comes as a surprise to some people, because they do not expect to have to pay taxes on money that hasn’t yet been paid to them. However, your bank should send you a Form 1099-INT each year notifying you as to 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 actually have a few good options:
1. Use outside savings to pay the tax
If you have enough savings outside of your CD to pay the tax, this may be the easiest solution. What helps is that, 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.
2. Choose a CD which makes regular interest distributions
Some CDs give you a choice when you sign up: Interest earned can be reinvested in the CD or it can be 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 make sure you have cash on hand to pay the taxes on that interest. Just be sure to make this choice when you sign up, because often the default option is to have interest reinvested in the CD.
3. 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 from which 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 ahead 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 cash to pay state taxes (if your state has an income tax) on your CD interest as well as federal taxes.
Upcoming tax needs should be kept in mind when it comes time to roll 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 full 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 in order to pay taxes on the interest those CDs earned. Then you can simply roll the remainder of 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 in 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 taken out of 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 that mature in time 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 coming 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/or 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 available outside of 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 CD rates available.
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 even 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 really need the branch-based service of a traditional bank anyway.
To make all of this easy, you can start just by looking ahead to this year’s tax obligations and set up a CD to meet those. Then you can gradually build out your CD ladder to anticipate tax obligations in upcoming years.
CD Frequently Asked Questions
Q: Is it reasonable for me to invest in a five-year CD at 2.20%? I am 80 years old. I am concerned about safety but I also want a fair interest rate.
A: At the heart of this question is the issue of how much someone should shorten their investment time horizon as they get older. People often go overboard in doing this, but depending on the details, a five-year CD is probably perfectly fine in your situation.
These are some key issues to consider when making this decision:
- Cash flow needs. Naturally, if you have a need for cash within the next five years that would require you to break into the principal of this CD, it might not be the most appropriate investment for you. However, if you can get by comfortably on the interest from this CD and your various other resources, then it may make sense to get a higher interest rate by choosing a five-year CD.
- Reliability of income. In assessing your cash flow needs as described above, you have to factor in whether your primary source of income is reliable. If you are comfortable it will continue to meet your needs, that is another argument for considering long-term investments.
- Competitiveness of the interest rate. Once you have decided that a five-year CD is appropriate, the next issue is whether the rate you are looking at is competitive. The 2.20 percent you mention would be among the best CD rates available.
- Safety. This entire discussion is based on the assumption that you are looking at an instrument from an FDIC-insured institution, and that the amount of your deposit falls within FDIC insurance limits of $250,000 per depositor, per covered institution. Otherwise, you would not be getting the total safety you want.
- Sustainability. The best approach to your finances at any age is to set them up to be as sustainable as possible. Assuming you have no short-term cash flow needs that have not been accounted for, long-term investments can make your financial situation more sustainable.
- Other investments. Consider this decision in the context of your other investments. Would this CD be redundant, or would it complement what you already have?
The irony is that by gravitating toward short-term deposits like savings accounts, people are generally trying to avoid risk, but risk is exactly what bit depositors when short-term rates plummeted to nearly zero. Risk comes in a variety of forms, so assuming you have more money than is necessary for your immediate needs, it is never too late to seek a balance between short-term and long-term investments.
Q: I haven’t had a job in several years, so I don’t file taxes. I have received money from my structured annuity, and would like to invest some of it in a CD. Do I have to pay taxes on the interest earned on a CD? If so, is there a certain minimum amount of income you need to earn before you have to pay taxes?
A: The most important point to be made here is that if you have income from any source, it may be subject to taxation. In other words, it’s not just employment income that gets taxed; interest, dividends and investment gains are all taxable.
As you suspect, though, there is a minimum threshold of earnings necessary before you have to pay taxes. The size of that threshold varies depending on your circumstances, especially your age and marital status. The earnings threshold for taxation can be as low as $3,700 if you are married and filing a separate return from your spouse.
You should go to the IRS web site and look at the instructions for Form 1040. These instructions include a table showing the different taxation thresholds depending on the taxpayer’s status. Look in the section titled “Do You Have To File?” to see the applicable income threshold for your filing status. If your CD and other income (which may also include the annuity proceeds you mentioned) exceed that amount, you should file a return.
By the way, since you mention possibly investing in a CD, there are some other tips that you might find helpful. Like all bank interest rates, CD rates are very low these days, but making the right choices can help you get a little more for your money.
- Always shop to find the best CD rates. CD rates can vary greatly from one bank to another, so don’t just settle for the first rate you find.
- Consider online banks for higher yields. Since CDs are a fairly passive type of investment, you may not need the type of personal service you can get from a local branch, and online banks frequently offer much better interest rates than traditional banks.
- Early withdrawal penalties are a key feature in today’s interest rate environment. You can typically get a higher interest rate from a longer-term CD, but you may be hesitant to lock yourself in for five years at today’s low interest rates. Finding a CD with a relatively small penalty for early withdrawal can be a way to benefit from a higher rate while leaving yourself some flexibility in case rates rise.
Q: When my CD matures, can I put it into a savings account without having to pay taxes on it?
A: The answer is yes and no. The maturation of a CD is not, in and of itself, a taxable event which would trigger the payment of taxes. However, this is only because your bank should have been including income on the CD in each year’s 1099 form. In short, if you’ve been declaring income from that form on your taxes, then you would have been paying the taxes on the CD interest year by year, as it was earned.
The one caveat is that if the CD was part of an IRA or other tax-deferred retirement plan, you will want to make sure the proceeds roll into an account which the bank has also set up as tax-deferred plan. Otherwise, the maturity of your CD could not only trigger a taxable event, but perhaps even a tax penalty if you are younger than retirement age.
Back to your question: with tax considerations out of the way, you can decide where to put the proceeds of the CD based on what kind of bank rate you can get. Assuming you have no short-term needs for the money, compare the best CD rates with rates on savings accounts–and don’t forget to include money market rates in the comparison. Money market rates are generally higher than savings account rates, and competitive with short-term CD rates, without requiring that you lock up your money for a specified period of time.
Q: How do I ladder my IRA CD without taxes or penalties?
A: CDs have the benefit of safety and predictability, which may be desirable if you are nearing retirement age and expect to be drawing from your CD in the near term. However, if you have several years until retirement or you 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 useful technique to manage cash flow or to hedge against changes in interest rates. However, if you have a few years before you have to worry 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 be benefiting 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, take a look to see if that bank is offering fully competitive CD rates.
On the MoneyRates CD rates page, the best CD rates across a range of different maturities pay well over 1% more than the national averages. Rates are updated every week, so take a look at that page before you settle for what your bank is offering.
How to avoid taxes and penalties
As you point out, avoiding taxes and penalties is an important consideration when making changes to IRAs with CDs.
Penalties Take a look at your current CD and find out what the interest rate, maturity date, and early withdrawal penalty are. If it is scheduled to mature soon or if it pays a competitive rate, you may want to wait until it matures before making any changes. Otherwise, you may you have more to gain by paying the penalty and shifting to a CD with a better rate.
Taxes If you decide to switch to another bank, inform both institutions that you want this to be a trustee-to-trustee IRA transfer. This allows you to change IRA custodians efficiently and without triggering tax consequences. The rollover to a new IRA must be made within 60 days, otherwise the withdrawal might be subject to taxation. (You should also check if either bank charges fees associated with a trustee-to-trustee transfer.)
Q: When are taxes on CDs due?
Taxes are due in the year when they are credited to an account, and a bank will credit your CD with interest earned throughout the term of the CD, not just at the end when the CD matures. So, if you invest in a five-year CD, you should still receive a Form 1099 from the bank for each year of that CD’s term, showing you the interest credited during that period. This amount is taxable in that year.
The reason it doesn’t really matter in the long run is an example of why tax-deferral schemes are often overrated. It doesn’t matter if you pay tax on interest year-by-year, or all at once after a period of years. Assuming the tax rate stays the same, any extra compounding effect would be negated by applying the tax rate to the compound total interest at the end.
You will find the best CD rates on longer-term CDs, and you can do better still by shopping for the best CD rates for any given CD length you choose. However, if you are saving aggressively, there is one tax issue concerning long-term CDs. Since tax will be due during each year of the CD’s term, but you won’t receive the proceeds till the CD matures, make sure this does not create a cash flow problem for you. That is, you will need to have the cash on hand from other sources to pay the tax each year.