Certificates of deposit (CDs) are great instruments for earning a little extra interest if you don't mind locking your money up for a specified period of time. They typically offer a fixed rate of interest and, when offered by a participating bank, they are backed by FDIC insurance (within the $250,000 limit per depositor).
There's only one thing to watch out for -- taxes. Taxes on CD interest may become due before you actually receive the money, which could cause a bit of a cash-flow problem. However, you can easily work around that problem if you plan ahead.
Tax implications: How do CDs work?
To understand why CDs can create a mismatch in timing between when interest is paid and when taxes on that interest are due, think about how CDs work. You agree to lock up your money for a specific period of time and, when the time is up, you get your original investment back plus all the interest you earned during the CD term. For the most part, though, that interest is being earned throughout the entire term, not just all at once at the end.
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This is known as accrued interest, which means it has been earned but has not yet been paid. Each year, your bank will report to the IRS the amount of CD interest you accrued during the year, and this will generally be treated as taxable income (unless the CD is in a tax-advantaged vehicle like an IRA).
Especially for long-term CDs, this may mean that accrued interest becomes taxable before it is paid. With your interest and principal still locked up in the CD, this means you would have to come up with the cash to pay the tax on your accrued interest.
Managing cash flow to pay CD tax
Here are some things you can do to manage your cash flow so you don't get caught short when CD taxes become due:
- When you open a CD, estimate your annual tax on the CD interest
This is simply a question of applying the annual interest rate to the amount invested in your CD and then applying your percentage tax rate to the resulting amount. This will give you an estimate of how much you'll have to come up with at tax time to pay the CD tax.
- Keep enough money liquid to cover your tax liability
Once you know how much you are likely to owe on the CD, a simple solution is to keep a sufficient amount available in a checking or savings account, rather than locking it all up in a CD.
- Use CD laddering to make money available at tax time
If you want to optimize your interest rather than settle for the lower interest rate you are likely to get from a savings or checking account, you could set up a CD ladder -- a series of CDs with different maturity dates -- that makes cash available each year to cover your CD taxes.
Paying taxes on accrued interest that has not yet been paid takes a little planning, but remember that it may allow you to earn more interest in the long run by capturing higher, long-term CD rates.