Q: I have a CD coming due this month. Will I just owe taxes on the interest when it matures, or will I also have to pay taxes on the principal? Also, would an IRA CD have the same tax advantages as a traditional IRA?
A: You should not owe any tax on the principal, because that should be the same as the amount you put into the CD. However, CD interest is taxable. That tax is not triggered by the maturity of the CD, but is payable on the amount of interest the CD accrues each year. The financial institution issuing the CD should provide you with a Form 1099 showing the amount of interest accrued for the most recent tax year.
As for an IRA CD, an IRA is a tax-deferred vehicle into which a variety of investments can be placed. So, 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 possibly penalties.
One key difference is whether you choose a Roth IRA or a traditional IRA. Contributions to a Roth IRA are not deductible, but you will not owe taxes on those contributions when you start withdrawing money from the IRA. You should talk to your bank about the pros and cons of Roth and traditional IRAs relative to your financial situation.
Whether you put your next CD in an IRA or an ordinary taxable account, there are some things you should do before you roll over a maturing CD:
- Take the opportunity to shop for the best CD rates. 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.
- 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.
- Think about changing the length of the CD. Right now, interest rates are particularly low, and long-term CD rates don't offer much of an advantage, so it may be a good time to go with a shorter maturity.
You should research these decisions as the maturity date approaches, so you will be ready to act when the time comes.
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