Dear Dr. Don,
Are CDs tax-deferred? If I take my money out of the stock market to buy five-year CDs, are they tax-deferred or will I have to pay the tax when I withdraw the monies?
-- Jim Jericho
Dear Jim,
CDs are only tax-deferred if they're held in tax-deferred accounts, such as an individual retirement account. Otherwise, the income is taxable in the year it is credited to the account.
That's true regardless of whether the money stays on deposit or is paid out to you on a regular basis. Your financial institution will provide you with 1099 forms listing the annual interest earnings.
Here's what IRS Publication 550, "Investment Income and Expenses," says on the topic:
Certificates of deposit and other deferred interest accounts. If you open any of these accounts, interest may be paid at fixed intervals of 1 year or less during the term of the account. You generally must include this interest in your income when you actually receive it or are entitled to receive it without paying a substantial penalty. The same is true for accounts that mature in 1 year or less and pay interest in a single payment at maturity. If interest is deferred for more than 1 year, see Original Issue Discount (OID), later.
Original Issue Discount (OID) OID is a form of interest. You generally include OID in your income as it accrues over the term of the debt instrument, whether or not you receive any payments from the issuer.
Series EE and Series I U.S. savings bonds allow you to defer paying federal income tax on the interest earnings until the bonds are redeemed or mature. No state or local income taxes are paid on savings bonds.
CD annuities have a tax-deferral feature, but they aren't right for everyone. Part of the reason for this is based on your age. Withdrawals from a CD annuity prior to age 59½ may be subject to a 10 percent penalty tax in addition to the deferred income taxes due on the interest earnings.