The One Way to Avoid Taxes on Your CD Earnings

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The interest your CDs pay you is usually subject to taxes. Read on to see how you can legally get out of paying them. [[{“value”:”

Even though the Fed just lowered its benchmark interest rate, CD rates remain fairly competitive. It’s true that 5% CDs may be gone at this point. But you can still earn a 4.50% APY, or something in that vicinity, if you shop around. With a $10,000 deposit, a 12-month CD paying 4.50% puts $450 in your pocket.

But there’s a big drawback to putting money into a CD. The interest it pays you is subject to taxes — and not just any taxes.

CD interest is taxed as ordinary income, which means it’s subject to the highest marginal tax bracket you fall into based on your earnings. So if you fall into the 24% tax bracket and earn $450 in interest from a CD, you’re looking at losing $108 of that to the IRS.

The good news, though, is that there’s a way to get out of paying taxes on your CD earnings — without breaking the law or lying to the IRS. But you’ll need to see if this strategy makes sense for you.

A perfectly legal way to get out of paying taxes on CD earnings

Opening a CD through your bank isn’t your only option for owning one. You can also see if your IRA allows you to hold CDs in your account. If so, you have options for easing your tax burden.

An IRA is an individual retirement account, and there are rules you need to follow if you decide to save in one. Not only are there contribution limits that can change every year, but you generally have to keep your money in an IRA until age 59 1/2 to avoid an early withdrawal penalty. However, the reason for these restrictions is that IRAs offer big tax benefits.

With a traditional IRA, your contributions go in tax free, and gains in your account are tax deferred. This means you don’t pay taxes until you take withdrawals. With a Roth IRA, your contributions go in on an after-tax basis, but gains in your account are tax free, and so are withdrawals.

If you decide to invest in a CD in a traditional IRA, you won’t pay taxes on your interest until you start taking withdrawals in retirement. And if you invest a Roth IRA in a CD, you won’t pay taxes on your interest income at all.

Is it wise to invest your IRA in a CD?

People generally fund IRAs to build savings for retirement. Because of this, you’ll need to think about whether a CD is an appropriate investment or not.

It’s generally best to invest your retirement savings in stocks for maximum growth. While CDs may be paying 4.50% today, the S&P 500’s average annual return over the past 50 years is 10%. That return accounts for years when the market soared and years when it tanked. But if you have a long investment window ahead of you, stocks are usually a better tool for growing retirement savings than a CD.

That said, if you’re very close to retirement, it’s generally wise to start scaling back on stocks and putting your money into safer investments. And CDs fit that bill.

That’s because with a CD, you’re not investing in an asset whose value can rise or fall over time. Your principal is generally protected as long as your CD is FDIC insured and your deposit falls within the FDIC’s $250,000 limit. With stocks, the value of your shares can change from one day to the next.

So if you’re 64 years old with plans to retire at 65, opening a 12-month CD in your IRA isn’t a poor choice — especially if you have a Roth IRA. That way, you get the benefits of a CD without the taxes. But if you’re 34 years old and retirement is a good 30 years away, then a CD probably isn’t where you want to put your money.

All told, using an IRA to hold a CD could either defer your tax obligation or get you out of it entirely. But if you don’t want to invest your IRA in a CD and you decide to just open one at your bank, plan for the taxes you’ll have to pay.

Set aside a portion of your interest payments for the IRS as you see them hit your account. That way, you won’t face any unpleasant surprises when you file your tax return.

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