Is Buying High-Yield CDs in Your IRA in 2024 Your New Tax Hack?

CD yields have risen sharply in recent years, which is a good thing for savers. It used to be difficult to find a yield above 2.00% from a CD, but yields of 5.00% or higher have become quite common in the rising-rate environment we're in.

However, one thing many people don't realize before they put money into their first CD is that the interest paid by CD accounts is taxable. And not only that, but it is typically taxed as ordinary income -- it doesn't get lower rates like capital gains or dividend income.

CD interest tax rules to know

CD interest is even taxable if you leave it in the account. Under IRS rules, interest income is taxable in the year it was paid. For example, if you open a 5-year CD with $10,000 and it has an APY of 4.00%, you'll receive $400 in interest income in the first year. Even if you don't withdraw a penny of it and leave it in the account to keep growing, you'll receive a tax form to claim $400 of interest income.

Speaking of tax forms, banks are required to issue tax documents (called a 1099-INT) if you earned $10 or more in interest income during the year. And in all income-related matters, if you receive a tax form documenting income, you can assume that a copy was sent to the IRS as well, so it knows about it.

One way to avoid tax on interest income is to earn it in retirement accounts, such as IRAs. Here's a rundown of how to buy CDs in an IRA, and why it might be a good move for you in 2024.

How to buy CDs in an IRA

There are two main options when it comes to putting money into a CD within an IRA.

First, you can open an IRA with a top-notch online broker (if you don't have one already). Most of the largest brokers, such as Charles Schwab and Fidelity, offer the ability to buy CDs directly through the brokerage platform. These are typically CDs known as "brokered CDs," which essentially means you buy them through your broker, but the CDs themselves are offered by third-party banks. One of the biggest advantages to this method is that you typically have many different banks' CDs listed in one place, and you can choose the best CD rate offered. In fact, the highest 5-year CD yield on our best CDs list as of this writing is a brokered CD offered through the Vanguard brokerage platform.

Alternatively, many banks that offer high-yield CDs allow you to open an IRA directly through them. As an example, Wells Fargo currently offers some high-yield CDs with special rates that you can open an IRA and buy. So, if you have a preferred bank (either branch-based or online), this could be a good place to start.

High yield: Open a Wells Fargo Standard CD now.

Do you qualify for a CD in an IRA?

There are two types of IRAs, and each one has different qualification requirements.

Technically, anyone can contribute to a traditional IRA. But if you (or your spouse) have a retirement plan at work, the ability to deduct your traditional IRA contributions is limited if your income exceeds certain thresholds. On the other hand, Roth IRAs are income-limited for everyone, regardless of other retirement plans.

Roth IRAs in particular could be interesting to many people, as you can withdraw Roth contributions (but not any interest or investment profits) at any time and for any reason, without penalty. So, if you don't necessarily want all of your money locked up until retirement, but want to avoid taxes on interest income, a Roth IRA can give you access to it.

The bottom line

Using an IRA to open a CD account is a smart move for many people, but it isn't for everyone. For example, it's one thing to leave your money tied up for five years in a CD. It's another to commit to leaving it in a retirement account for decades. In most cases, with the big exception of Roth deposits as discussed earlier, you can't take money out of an IRA until you're at least 59 1/2 years old or you'll face a 10% early withdrawal penalty.

It's also important to mention that if you use your IRA to put your money into CDs instead of other investments like stocks, it can hurt your long-term returns. But if you have adequate retirement investments already (you have a 401(k) at work, for example), this can be a nice way to supplement your long-term savings in a tax-advantaged way.

The bottom line is if you don't think you'll need the money for a long time, you qualify to utilize an IRA, and you haven't yet maxed out your IRA contributions for the current year, buying CDs in an IRA can be a nice way to enjoy the highest yields in years without getting a tax bill at the end of the year.