Remember those little disks that used to come in the mail from America Online? You should have been saving those CDs! No, we're only kidding! But we hope we made you giggle. In the financial world, CD means a Certificate of Deposit. Here, we'll talk about CDs and the tax implications of CDs.
How a Certificate of Deposit Works
You can purchase a Certificate of Deposit at any bank or credit union. In a nutshell, you'll spend a lump of cash — say a few hundred or a few thousand dollars — and the bank will invest it. CDs usually provide better interest rates than a checking or savings account, and that money is guaranteed to be safe. Unlike the stock market, there is no risk that you'll lose the money you've spent on a CD.
- When you purchase a CD from your favorite financial institution, you'll agree on a date that you can retrieve those funds, plus interest.
- You cannot withdraw that money early, however.
- If you do, there will be a penalty.
The Beauty of CDs
A Certificate of Deposit is a great way to set aside money for a little while or a long time. They can help you save for expected expenses — like the winter holidays, a looming retirement, or college education. Most banks offer CD programs that allow you to invest your money for six months, one year, or even five years.
Most CDs are acquired directly from a bank, but some independent salespeople and brokerages offer CDs. These entities, known as "deposit brokers," might be able to negotiate a better interest rate for you, because they're handling multiple CDs and bringing more money to the table.
However, we would encourage you to be very cautious. Research a brokerage or salesperson very thoroughly before handing over your hard-earned money!
- Deposit brokers are not licensed or certified.
- No state or federal agency approves them or monitors their behavior.
- Since anyone can claim to be a deposit broker, always check whether the deposit broker or the company he or she works with has a history of complaints.
Remember, when it comes to your money, you should never feel pressured to invest. Take your time and read the fine print. When in doubt, deal with a bank.
What are the Tax Implications of CDs?
The interest earned by a Certificate of Deposit is income, so it is taxable. You'll pay taxes on this income. Know that the banks who are holding these funds are reporting them to the IRS. There is no way to dodge the income tax on CD interest.
For short term CDs in small amounts, this shouldn't cause much stress. Let's imagine:
- On January 1, 2020, you invest $1,000 in a CD for one year at 2% interest.
- One year later, you cash in your CD at $1,020.
- That $20 income will be reported to the IRS. You'll need to claim it on income taxes. Depending on your tax status and state, you might owe $5, not enough to make or break someone
However, the IRS says interest can't build for more than a year without being claimed as income. So, for long term investments in large amounts, things can get tricky.
Taxes on Larger, Longer CDs
For the sake of simplicity, we'll keep the math smooth. Consider:
- On January 1, 2020, you invest $100,000 in a CD, for 5 years with 5% interest.
- In 2021, your CD is worth $105,000.
- You've earned $5,000 interest but haven't collected it. You'll still need to pay income tax on the interest, which could be as much as $1,000 or more, depending on your situation.
- In 2022 your CD is worth $112,500. You've earned another $5,250 interest but haven't collected it. You'll need to pay taxes on this new interest.
- Over the next years, you'll earn even more interest, and continue to pay income tax every year, until you finally cash in the CD.
- Eventually, this CD will be worth something like $129,000. It will earn the owner close to $30,000, and he or she will need to pay taxes around $6,000 over the years.
Remember, the bank will report your CD interest to the IRS, there is no dodging that bullet. So ultimately, CDs are an excellent way to set aside money for the future. They're safe and generate significant interest. Just be aware that the taxman cometh!