Since the Federal Reserve has raised its federal funds effective rate to the highest since December 2007, interest rates on various types of loans have also increased. That’s bad news for anyone trying to take out new loans like mortgages or lines of credit, but good news for people looking to make more money on their non-invested savings by lending money. Certificates of deposit (CDs) pay you an agreed-upon rate in exchange for lending your money to a bank for a set period of time. But the higher interest rates being paid by CDs is only part of equation. The other part is the taxes owed on those interest rates. Let’s break down how CDs are taxed. A financial advisor can help you optimize your financial plan to lower your tax liability.
How CDs Work
A CD is a financial product that allows you to deposit a certain amount of money for a fixed amount and earn a fixed interest rate. Functionally, a CD is a loan you are making to the financial institution that issues the CD. It is a deposit account that is insured by the Federal Deposit Insurance Corporation for up to $250,000.
While you can take money out early before the end of your CD’s term, you’ll have to pay a penalty of varying severity depending on the financial institution, terms of your agreement, and the length of time you left the money in the CD. The exception to this rule is the no-penalty CD.
How Are CDs Taxed?
The interest rate a CD pays you is called a yield. The yield of your CD is taxed as interest income by the IRS and taxed at your ordinary income tax rate, which is usually much higher than taxes on other forms of investment growth like capital gains. Long-term capital gains tax rates can be 0% – 20% at the federal level, whereas ordinary income tax rates can go as high as 37%.
In addition to federal taxes, your CD yields will be taxed at the state and even local level depending on where you live.
How to Report CD Income on Your Tax Return
The institution that holds your CD will provide you with a 1099-INT statement at the beginning of the year that will detail your CD yield for the previous year. You’ll get this even if you didn’t cash out the money on your CD and instead invested it into a new CD. If your CD has a yield over $10, you’ll get a 1099. Your 1099s from all sources will be included in your tax return under Line 3 on a standard 1040 as “Other Income.”
You may need to include a Schedule B for “Interest and Ordinary Dividends” if you meet any of the IRS requirements, including having over $1,500 of taxable interest or ordinary dividends the prior tax year.
Are There Ways to Avoid Paying Taxes on CDs?
You can avoid paying taxes on your CD yields by having your CDs in tax-advantaged accounts. You can have CDs in Individual Retirement Accounts, 529 plans, Health Savings Accounts, 401(k)s, and so on. CDs may not be a wise thing to hold in your retirement accounts as they have minimal growth compared to other investments but speak to a financial advisor to see what’s right for you.
You can reduce your total tax burden by doing proper tax planning. Taking advantage of available deductions, maximizing pre-tax accounts to lower your taxable income and increasing charitable contributions are all ways to reduce or eliminate the taxes you’ll pay on CDs.
Is Putting Money in a CD a Good Idea?
A CD is sometimes jokingly referred to as a Certificate of Depreciation. While CD interest rates are currently relatively high, so is inflation. Locking money into a CD guarantees a rate of return, but you may get a similar or better rate with a high-yield savings account or Series I savings bonds. While I bonds lock up your money for at least a year to get a return on your investment, a high-yield savings account keeps your money available in case of emergency while it goes to work for you. Strategically moving around large sums of money to different accounts for new-customer signup bonuses can also net you a higher yield than a CD while keeping your money more accessible.
If you’re considering putting your money in a CD to protect it from market volatility and recession fears keep in mind that you may not want to pull out of investing entirely. Past performance can’t guarantee future results, but historically market downturns have been the best times for people to invest their money for long-term growth. Well-diversified investments can sometimes beat high inflation rates, but CDs almost never can.
Bottom Line
The interest rate your CD earns, called the yield, is taxed at your ordinary income tax rates. While CD rates are high now, consider alternative options like high-yield savings accounts to preserve access to your money or Series I Savings bonds, which may pay higher yields than a CD.
Tips on Taxes
A financial advisor can offer insight and guidance as you work to handle your securities in a tax efficient way. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Use our no-cost income-tax calculator to get a quick estimate of what you will owe the federal government.
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Source: https://finance.yahoo.com/news/much-taxes-cds-going-set-140019525.html