How to Avoid Taxes on CD Interest

(CDs) are a valuable tool for diligent savers. CDs allow you to earn higher interest rates than a traditional savings account, and your returns are guaranteed with a fixed interest rate for the life of your CD. The catch is that you can only get your money once your CD matures, without any fines being imposed.

Although CD income can be significant, there are tax implications to consider. The IRS treats CD interest income as taxable income, which you must pay every year. However, there are some ways to avoid paying taxes on CD interest. Read on to learn how.

Do you pay taxes on CD interest?

Generally, you must pay taxes on CD interest.

CD interest over $10 is considered taxable income and you must report this income on your tax return.

CDs come in different lengths or terms. The term can vary from less than one month to five years or more. Regardless of the term, you must pay taxes on the interest your CD earns. If the term of your CD is less than one year and matures within the same year that you open the CD, report this income on your tax return for that year. But if the term of your CD is longer than one year (or spans multiple years), you’ll pay taxes on the interest you earn at the end of each year. In the latter case, you report interest income on multiple, consecutive tax returns.

Generally, you must pay taxes on your CD earnings regardless of how you receive interest payments. For example, you may have the option to withdraw your interest earnings before the due date, or you can leave the interest earnings in your account and allow this. Either way, you have to pay tax on that income.

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Tax consequences of early withdrawal penalties

Normally, you cannot withdraw the principal amount of your CD without consequences. If you do, you’ll probably have to pay. Many financial institutions charge these penalties based on the length of a CD’s term. Early withdrawal and payment of the resulting costs also has tax consequences.

You can deduct the amount of the early withdrawal penalty from your taxable income. For example, if you pay $20 in early withdrawal penalties, you can deduct $20 from your gross income. Any early withdrawal penalties you paid should be recorded in Box 2 of that tax year.

How to Avoid Taxes on CD Interest

Although you usually have to pay taxes on CD interest, there are some ways you can avoid or delay it. Keeping your CDs within certain types of accounts, including IRAs, 529s and HSAs, can help ease your tax burden.

IRAs and other retirement accounts

Contributions to a deferred retirement account, such as a traditional 401(k) or , are generally tax deductible up to contribution limits. And you usually don’t have to pay taxes on your income until you retire.

To defer taxes on CD interest until retirement, you can open a CD within a tax-deferred retirement account, whether it is an employer-sponsored plan or an IRA.

529 plans

529 plans allow you to save and invest for education expenses while taking advantage of tax benefits. Although contributions to 529 plans are not tax deductible, you do not have to pay taxes on income used for qualified education expenses, such as tuition, books and housing. While you can invest in things like ETFs and mutual funds within a 529, you can also invest in insured products like CDs and potentially avoid paying taxes on that CD income.

Health Savings Accounts (HSAs)

Health Savings Accounts (HSAs) offer a triple tax benefit: Contributions are tax-deductible, interest grows tax-free, and distributions are tax-free when you use them for qualified medical expenses.

HSAs are a strategic tool you can use to save for healthcare costs such as insurance premiums, prescriptions, devices and more. But to take advantage of an HSA, you must meet certain eligibility requirements; most notably, you must be enrolled in a high-deductible health plan.

Like IRAs and 529 plans, there are several investments you can purchase within an HSA, and your options depend on the financial institution that holds your account. If you invest in CDs within your HSA, you can avoid paying taxes on the interest, provided you use distributions to pay the eligible expenses.

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Frequently Asked Questions (FAQs)

What happens if you don’t report CD interest on your tax return?

If you do not report CD interest or other interest income on your tax return, you may receive an Underreported Income Notice (CP2000 Notice). This notice indicates a discrepancy between the amount of income you reported and the amount reported to the IRS by your employer and other third parties.

If you did not report CD interest on your tax return, you will be required to pay the taxes you owe, plus interest, in response to receiving this notice. If you don’t respond quickly, you may have to pay additional interest and penalties.

How much tax do I have to pay on CD interest?

Interest income is taxed as ordinary income, meaning it is subject to your .

Are CDs taxed at the state level?

Income from CDs is subject to state and even local taxes, and you may have to pay these taxes depending on where you live. However, not all states have income taxes. Other states have different tax structures, some with flat rates and others with graduated rates. Basically, whether you pay state taxes on CD income and how much you pay depends on where you live.