How CDs Are Taxed: Tax Planning Guide

Certificates of deposit (CDs) offer a predictable way to earn interest, but understanding how taxing CDs work can help avoid surprises at tax time. The IRS treats interest earned on CDs as taxable income, even if it remains in the account and isn’t withdrawn. Most banks report this interest annually on a Form 1099-INT, and it is typically taxed as ordinary income based on the account holder’s tax bracket. While traditional CDs generate taxable interest each year, tax-advantaged accounts like IRAs may allow deferral of taxes on CD earnings, depending on the type of account and contributions made.

A financial advisor can help you decide where to hold CDs and how to manage the tax impact of interest income as part of your broader financial plan.

What Are CDs and How Do They Work?

A CD is a fixed-term savings account offered by banks and credit unions that pay interest in exchange for leaving funds untouched for a set period. Unlike regular savings accounts, CDs typically offer higher interest rates but impose penalties for early withdrawals. The term length can range from a few months to several years, with longer terms often yielding higher rates.

When opening a CD, the account holder agrees to a fixed interest rate and maturity date. Interest accrues over time, and at maturity, the depositor can either withdraw the funds or roll them into a new CD. Banks may offer different types of CDs, including traditional and high-yield accounts, each catering to different financial goals.

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.

Do You Pay Taxes on CD Interest?

CD interest is considered taxable income in most cases, even if the funds remain in the account and are not withdrawn. The IRS requires that earned interest be reported annually, meaning taxes may be due on the interest before the CD matures. This is because CDs accrue interest over time, and banks typically report these earnings each year on Form 1099-INT if the total interest exceeds $10.

The way interest is taxed depends on when it is credited. For CDs that compound annually or monthly, the interest earned in a given year is taxable, regardless of whether it is withdrawn. Even if a CD has a multi-year term and interest is paid at maturity, the IRS may still require annual reporting based on accrued interest.

Tax treatment can vary for CDs held in tax-advantaged accounts, such as IRAs, where earnings may be deferred or exempt from taxes. However, for CDs in standard taxable accounts, interest is typically taxed as ordinary income at the account holder’s marginal tax rate.

How to Report CD Income on Your Tax Return

The tax you owe on CD interest depends on your overall income and tax bracket, not just the rate the CD pays.

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.

How to Avoid Tax on CD Interest

While CD interest is generally taxable, certain strategies can help defer or reduce tax liability. Here are some options to consider:

Time CD maturity for lower tax years: CD laddering can help time interest payments for years when income is lower, potentially reducing the overall tax burden.
Use tax-advantaged accounts: Holding CDs in a Traditional IRA allows interest to grow tax-deferred until withdrawals begin. Roth IRA CDs offer tax-free growth if withdrawals meet IRS requirements.
Invest in municipal bonds: Unlike CDs, municipal bond interest is often exempt from federal income taxes and may also be state tax-exempt if issued by your home state. However, these bonds carry different risks than CDs.
Consider U.S. Treasury securities: Treasury bonds and I bonds offer tax advantages. Treasury bond interest is exempt from state and local taxes, while I bond interest can be deferred until redemption.

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.

Common Tax Mistakes CD Holders Make

One of the most frequent mistakes is assuming that taxes on CD interest are only owed when the money is withdrawn. The IRS requires interest to be reported in the year it is earned or credited, not the year it is taken out of the account. A client who opens a five-year CD and does not touch it until maturity may still owe taxes on the interest that accrues each year along the way.

Multi-year CDs that pay all interest at maturity can create confusion around timing. Some banks report accrued interest annually even if it is not paid out until the CD matures, while others may report the full amount in the year of maturity. If a large lump of interest shows up on a single year’s tax return, it could push the account holder into a higher tax bracket. Checking with the issuing bank on how and when interest is reported can help avoid this surprise.

Many holders of taxable CDs overlook the fact that early withdrawal penalties are tax deductible, which can offset some of the cost of cashing out a CD before it matures. If you cash out a CD before it matures and the bank charges a penalty, that amount can be deducted on your federal return as an adjustment to income. It appears on Schedule 1 of Form 1040 and reduces adjusted gross income regardless of whether you itemize.

CD interest can also affect income-based thresholds that many people do not think about. For retirees, additional interest income can increase provisional income and cause a larger portion of Social Security benefits to become taxable. It can also push modified adjusted gross income above the levels that trigger Income-Related Monthly Adjustment Amounts, which are surcharges added to Medicare Part B and Part D premiums.

For taxpayers who earn significant CD interest alongside other income, failing to adjust estimated quarterly payments is another common error. If you are self-employed or have other income not subject to withholding, a large CD portfolio generating thousands of dollars in annual interest can create an underpayment penalty at filing time. Updating estimated payments to account for expected CD interest can help avoid this.

State tax treatment may also differ from federal. While CD interest is taxable at the federal level in nearly all cases, state rules vary. A few states do not tax interest income at all, while others tax it at their full ordinary income rate.

Bottom Line

Interest earned on a CD is taxed as ordinary income, regardless of whether you withdraw it or leave it in the account.

The interest you earn on a CD is taxed as ordinary income at your marginal tax rate. While the yield represents the rate of return on the CD, the amount you actually owe in taxes depends on your income and tax bracket. 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 vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel 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.