Got a CD in 2023? Your Tax Bill Might Be Higher Than You Think

Certificates of deposit (CDs) are a low-risk investment that give you a guaranteed rate of return for a specific term, like 12 months. Last year, for the first time in over a generation, the best CD rates exceeded 5%, with some even going higher than 6%. And while earning 5% on your savings can yield a decent chunk of change, don't count on all of it staying within your possession. 

Like other interest-bearing accounts, CD interest totaling $10 or more is taxable and must be reported on your tax return. The rate from your tax bracket is the same rate used to tax your CD earnings (in 2023, they range from 10% to 37%). So, if you earned $2,000 in CD interest and your tax rate was 22%, you'd pay $440 in taxes. Note: You might also have to pay state and local taxes on CD earnings, too. 

How do taxes work for long-term CDs?

The interest you earn in long-term CDs, or those with terms longer than one year, is taxed in the year it's accrued at your applicable tax rate. This applies even if you don't withdraw the interest from your CD account. 

For example, let's say you took out a 3-year CD on Sept. 30, 2023, and it accrues interest monthly. For 2023, you would pay taxes for three months of accrued interest (October, November, and December). In 2024 and 2025, you would pay taxes on interest accrued for the whole year, and, in 2026, you'd pay taxes on interest accrued up until your CD's maturity date. And yes -- you would pay these taxes even if your bank doesn't let you withdraw funds from your account. 

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How do taxes work for short-term CDs?

For short-term CDs (those with terms of 12 months or less), you'll pay taxes in the year the CD matures. The exception is 12-month CDs, which could technically span two calendar years. In this case, if your 12-month CD accrued interest monthly or quarterly, you would pay taxes in both years. 

What about early withdrawal penalties?

Most standard CDs charge penalties when you cash in early. Usually, the penalty is equal to a period of interest, like six months' worth, and you'll pay it regardless of how much interest you actually earned.  

Much like tax loss harvesting with stock investments, you can deduct early withdrawal penalties from your taxes. For instance, let's say you deposited $10,000 in a 6-month CD with a 5.50% APY and an early withdrawal penalty worth three months of interest. You earn one month's worth of interest (about $45.83) before breaking your CD, thus incurring the penalty ($137.50). Even though you technically only paid $91.67 (the penalty minus the interest you earned), you can deduct the full $137.50 from your taxes. 

Is there any way to avoid paying taxes on CD interest?

The only way to avoid paying taxes on CD interest is to house your CD within a tax shelter, like an IRA or 401(k). Otherwise, you likely receive a 1099-INT from the financial institution that issued your CD, which you'll then report to the IRS. 

Most tax software can help you fill out a 1099-INT, which reports how much income you earned throughout the year, including CDs, savings accounts, and money market accounts, among others. The instructions are easy to follow, but if you're ever in doubt, don't hesitate to reach out to a tax professional. You don't want to wind up owing money later, or worse -- having your taxes audited.