Q: I know that the best CD rates are typically on longer-term CDs, but I was also wondering whether there was any tax advantage to choosing long-term CDs. If I don't have to pay taxes until the CD matures, am I effectively earning tax-free income in the interim?
A: Unfortunately, no, interest on a certificate of deposit (CD) does not accrue tax-free. But in the long run, it shouldn't matter.
When taxes on CDs are 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.
CDs and tax issues
You are correct that 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.
Find the best CD rates for a variety of terms between 1-month CDs and 7-year CDs on MoneyRates.
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Comment: How do you approach taxes on CDs during tax season?
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