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.
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:
- 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.
- Choose a CD which makes regular interest distributions
Many 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.
- Set up a CD ladder
A CD ladder is a series of CDs 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.
This comes into play 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.
What to do before Your CD Matures
Whether you put your next CD into an IRA or an ordinary taxable account, there are some things you should do before you roll over a maturing CD:
1. 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.
The nature of CDs is that they require longer commitments of your money in exchange for higher interest rates. This can be a good way to earn more on your savings, as long as you make sure those commitments don't get in the way of keeping up with your tax obligations.
2. 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.
3. Think about changing the length of the CD
Stay aware and be willing to adjust your strategy to current economic conditions. As interest rates fall, it's time to lock in the best interest rate for a longer period of time. When interest rates are particularly low, 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 are ready to act when the time comes.
>> Check if your CD is losing value to inflation: CD Inflation Calculator