cds

Fund CD with Social Security and pay tax?

Don TaylorQuestionDear Dr. Don,
If I take my Social Security income and invest some into CDs, do I have to still pay taxes on it when it matures?
-- Joaqina Juncture

AnswerDear Joaqina,
The interest income on a certificate of deposit, or CD, is taxed as ordinary income on your federal income taxes. It doesn't matter that you funded the CD with your Social Security income. Whether your Social Security income is subject to federal income taxes is a separate question not discussed in this reply. The Internal Revenue Service Publication, "Seven Facts About Social Security Benefits," provides some guidance on that topic.

Whether you pay the taxes at maturity or in the year earned depends on the method you use to report income, and the term of the CD. Your financial institution will provide you with a Form 1099 each year stating your interest income for that year.

IRS Publication 550, Investment Income and Expenses, has a section on "When to report interest income," that states:

When to report your interest income depends on whether you use the cash method or an accrual method to report income.
Cash method. Most individual taxpayers use the cash method. If you use this method, you generally report your interest income in the year in which you actually or constructively receive it. However, there are special rules for reporting the discount on certain debt instruments.

Constructive receipt is more narrowly defined than what you'd expect. Again, from Publication 550:

Constructive receipt. You constructively receive income when it is credited to your account or made available to you. You do not need to have physical possession of it. For example, you are considered to receive interest, dividends or other earnings on any deposit or account in a bank, savings and loan, or similar financial institution, or interest on life insurance policy dividends left to accumulate, when they are credited to your account and subject to your withdrawal. This is true even if they are not yet entered in your passbook.

You constructively receive income on the deposit or account even if you must:

  • Make withdrawals in multiples of even amounts.
  • Give a notice to withdraw before making the withdrawal.
  • Withdraw all or part of the account to withdraw the earnings. 
  • Or pay a penalty on early withdrawals, unless the interest you are to receive on an early withdrawal or redemption is substantially less than the interest payable at maturity.

Publication 550 also addresses your question in the Interest Income section:

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 one year or less and pay interest in a single payment at maturity. If interest is deferred for more than one year, see Original Issue Discount, or OID, later.

I'd love to simplify my reply and take out all these IRS references, but it's the IRS that decides when you owe the tax on your investment income. I would look to the Form 1099 you receive from your bank, as Bankrate's Tax Adviser, George Saenz, discusses in an earlier column, "When is a CD's interest taxed?" You can also talk to your banker about when you constructively receive the interest income on your CD. You can also get free tax advice from the IRS using its telephone assistance service.

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