Paying tax on CD interest

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Certificates of deposit (CDs) provide a safe place to earn a fixed return on your money, but any interest you earn totaling $10 or more is generally taxable and must be reported to the Internal Revenue Service (IRS).

Paying tax on CD interest puts a dent in your overall return. So before you invest, it’s important to know what CD interest is subject to taxes and what the IRS counts as income.

Here’s what you should know about CD interest and taxes.

Taxing CD interest

The IRS treats interest you receive on a CD as interest income, regardless of whether you receive the money in cash or reinvest it in a new CD. The same treatment applies for any interest credited to an account that can be withdrawn without penalty. The interest is taxable, the IRS says, in the year it becomes available to you.

If you’ve earned more than $10 in interest, the financial institution that issued the CD will typically send you a 1099-INT statement. In box 1, you’ll find the details of how much interest you earned that year from the CD.

For example, if you purchase a six-month CD maturing in the same year it was purchased and earn $10 or more, you’ll have to pay tax on it for that year. For multi-year CDs, you’ll pay taxes on the interest accrued on the last day of each year. Even if you don’t receive a 1099-INT, you must report interest earnings of $10 or more.

The caveat is if you house your CD in an tax-deferred individual retirement account (IRA) or 401(k). As long as money placed in a traditional IRA is below the annual contribution limit ($6,000 for 2020, or $7,000 if you’re 50 or older), interest you earn in a given tax year may be tax deductible. In that case, no 1099-INT is issued until distributions are taken from the retirement account.

Keep in mind that the tax rate on CD interest depends on the dollar amount of your gain and what income tax bracket you fall under.

When does cashing a CD count as income?

You earn interest on the principal amount of your CD over time until you cash it out at maturity. But only the amount that exceeds your initial investment usually counts as income.

Let’s say you purchase a one-year CD for $10,000 that pays 1.10 percent APY. When your CD matures, you will have earned around $110. The issuing bank will give you a total of $10,110 (your principal investment plus interest earned) at maturity. Yet only the $110 in interest qualifies as income, and that’s the amount you’ll see in box 1 on the 1099-INT received from the bank at tax time.

When is tax due on a CD?

Per IRS guidelines, any interest earned on a CD is generally due the year it becomes available to you, whether you receive it or are entitled to receive it.

For example, let’s assume you purchase a six-month CD in early 2021 that matures in July 2021. You would report any interest earned from that CD on your 2021 tax return.

Interest earnings from long-term CDs, with maturities of more than one year, must be reported annually as well. If you purchase a five-year CD, for example, you’d report interest income for each year you own the CD.

For example, if you purchase a five-year CD for $10,000 that pays 2.00 percent APY on Jan. 1, 2020, the $200 in interest you earn in 2020 will be taxable in that year. Interest earned in each of the remaining four years of the five-year CD will qualify as income and be taxable in the year it’s earned.

How early withdrawal penalties affect taxes owed

In some cases, early withdrawal penalties may reduce your tax obligation.

Most traditional CDs charge penalties for taking out money before the maturity date. If you pay an early withdrawal penalty, you can deduct the full amount on taxes, even if it’s an amount that’s greater than the interest earned. So, if you earned $50 in interest, but you pay an early withdrawal penalty of $100, the full $100 can be deducted on taxes.

Any early withdrawal penalties will be included in box 2 of your 1099-INT form from the issuing institution and clearly labeled “early withdrawal penalty.”

Bottom line

Generally, you must report CD interest earnings of $10 or more to the IRS. But CD taxes aren’t always clear-cut. If you aren’t sure if you’ve received interest earnings, or if you have other questions about CD tax-related issues, be sure to consult a tax professional.

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