How Are Certificates of Deposit Taxed?
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Definition of Certificate of Deposit
A certificate of deposit (CD) is an investment deposit account that is widely used as a savings and retirement product. This investment product can have a term ranging from no less than a week to upward of 20 years or more. CDs are considered one of the safer investment products, as the principle investment cannot be lost due to market fluctuations. ICDs represent gain because the principle investment accrues interest at either a fixed or variable rate throughout the term of the investment.
When Taxes Are Due on a CD
As with many investment products, the principle of a CD is not taxable. However, the interest earned on certificates of deposit is subject to taxation at the federal level. Interest is not subject to taxation while it is accruing, only once it is earned. For example, a $1,000 CD at a fixed rate with a five-year term earning interest on a semiannual basis will be subject to taxes every six months until maturity. While interest is accruing during each six-month period, taxes are not due. However, once each six-month accrual period ends, taxes are due, because interest is earned every six months as per the investment agreement of the CD.
Interest Earned Versus Interest Paid
There is a difference between interest earned and interest received or paid. Interest earned is the amount of interest that has accrued for a set period. At the end of the accrual period, the interest is available for disbursement or payment. Interest received or paid occurs when the interest earned is disbursed or paid to the account holder. This means that even if a person decides to roll over the interest into the principle (compound it)
in lieu of receiving a payment, this same interest is still taxable, because it was earned.
Taxation for Different Types of CDs
Not all CDs are taxed the same. CDs with deferred interest are subject to a tax penalty if withdrawn early. A discount CD is a type of deferred-interest CD; with a discount CD, if interest is withdrawn early, the standard taxes are due and a penalty tax for early withdrawal is imposed. This penalty tax is typically 10 percent of the amount withdrawn.
Discount CDs are certificates of deposit that are purchased for an amount that is lower than the face value or principle of the certificate. Typically, the interest earned on these CDs equals the discount amount of the deposit. This means if a CD has a face value of $5,000 but is purchased for $4,500, the interest earned over the life of the CD will total $500, which is the discount amount of the CD. The $500 is taxable once earned, as with any other CD.
CDs that are renewed or rolled over into a new CD are considered redeemed. This means that interest is still owed on the original CD, because in order to renew or roll over a CD into a new one, the original CD must first mature. At maturity, interest is considered earned, even though it was never received but rolled over into a new CD.
Remember that while certificates of deposit are purchased with the consumer's own money, the CD does earn the purchaser income. As far as the IRS is concerned, all earned income is subject to taxation. As the interest earned on a CD is considered income, it is taxable.Source: ehow.com