When do you pay tax on a CD?

eddie — Wed, 31 May 2006 07:11:06 +0000

Question: Hi, I was wondering if there is any advantage to putting money into a CD versus a regular savings account (like Emigrant Direct or ING) if the rates are same or very close.

On the one hand, a savings account is more liquid than a CD. On the other, a CD is set at a particular rate, so even if the rates fall, you’ll still be locked in. Anything else?

I’m wondering because some I’m seeing some places with rates like 4.75% for regular savings accounts, and others places with 6 month CD’s for 4.75%.

Thanks!

Answer: You hit the big ones – the tradeoff between liquidity and rate security. In addition, there may be tax reasons that you’d prefer one instrument over another.

Interest from both certificates of deposit and savings accounts is classified as income. Generally, income is taxable in the year in which it is received. Many CDs pay interest in one lump sum, when the CD reaches maturity. Savings accounts, on the other hand, generally pay interest each month.

If you have a large income this year, but expect to have a much smaller income next year, it may behoove you to choose the CD over the savings account – you would delay the taxable event (your receipt of the income) until next year, when you’ll be taxed at a lower rate. Alternatively, if you expect to have a large income next year but have a much smaller income this year, you would likely come out ahead by choosing the savings account.

The above holds true for CDs with terms of 1 year or less, but things get a little trickier when the term is over 1 year. Depending on how the CD is structured, you may have to pay tax on a portion of the total interest due. Forbes offers the following bit of advice in a January 2006 article:

If you buy a CD with a maturity of more than a year, you must include as income each year a part of the total interest due. This applies to similar deposit arrangements, such as time deposits, bonus plans, savings certificates, deferred income certificates, bonus savings certificates and growth savings certificates.

While that sounds fairly straightforward, it’s not quite as simple as Forbes would have you believe. IRS Pub 550 covers investment income and expenses. According to Page 5 of that publication,

“Certificates of deposit and other deferred interest accounts. If you open any of these accounts, interest may be paid at fixed interval of 1 year or less during the term of the account. You generally must include this interest in your income when you actually receive it or are entitled to receive it without paying a substantial penalty. The same is true for accounts that mature in 1 year or less and pay interest in a single payment at maturity. If interest is deferred for more than 1 year, see Original Issue Discount (OID), later.” (emphasis added)

So, it would seem that according to the IRS, you need only claim the income if 1) you are “entitled” to receive it before the instrument matures and 2) there is no “substantial penalty” for early withdrawal. But it doesn’t stop there – even if you think that you’re in that situation, you may have issues to work out with the OID (found on page 14).

Confusing, I know. Which is probably why the Forbes article fibbed a bit.

It seems that a good rule of thumb is that for CDs with a term of less than one year, no tax is due until the CD matures, so you may safely use the above strategy when choosing between a CD and a savings account. If you’re looking to buy a CD with hopes of delaying a taxable event for more than one year, though, you might want to talk to professional first.

Good Luck, and Happy Investing!

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Is there any advantage to putting money into a CD rather than a regular savings account if each pays the same rate?

eddie — Wed, 31 May 2006 02:48:06 +0000