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MoneyWatch: Managing Your Money
When you earn money, you can expect to pay taxes on those earnings. That's typically the case whether you earn money at work, when you make an investment or when youearn interest on a deposit account. In fact, the IRS requires you to report any interest you earn over $10 per year — and that interest is typically taxed as ordinary income.
If you earn a meaningful amount of interest but don't consider the tax implications of those earnings, you could be in for an unwelcome surprise during tax season. But, the United States tax code is a complex one — and in many cases, it offers ways to reduce or even eliminate tax burdens if there are certain circ*mstances at play. So, is there any way to avoid paying taxes on certificate of deposit (CD) account interest you earn?
Open a CD now to lock in today's high returns.
Can you avoid taxes on CD account interest?
It is possible to either defer paying taxes on CD interest to a later date or to avoid taxes altogether. The key to doing so is holding your CD in a tax-advantaged account. Here are three ways to avoid taxes on the interest your CDs earn:
Open your CD as part of a retirement account
"You can make just about anything your IRA; for example, your CD, mutual fund, annuity, brokerage account, etc," Joel Ruso, owner and retirement advisor at NJ Retirement Planning,recently told CBS News.
When you invest in a CD as part of your IRA, your CD enjoys tax advantages. With a traditional IRA, investments are made on a pre-tax basis. So, your income taxes will be deferred until you tap into your IRA in retirement. If you opt for a Roth IRA, your money grows tax-free. You do pay income taxes on the money you open the IRA with, but you won't pay income taxes on its growth.
Open a CD now to make your money work harder for you.
Open a 529 CD
529 savings plans are designed to give consumers tax advantages in exchange for saving for the costs of higher education. And, several financial institutions offer CDs specifically for 529 savings plans.
So, what's the tax advantage that comes with these accounts? You won't have to pay taxes on your earnings as long as you use the money you've saved to pay for qualified education expenses. Those expenses include tuition, room and board, meal plans, books and more.
Open an HSA CD
Healthcare can get expensive quickly. If you're not prepared for healthcare expenses, the mounting costs could force you into financial hardship. The good news is that the IRS incentivizes you to save for these events by offering tax advantages on health savings accounts (HSAs). Moreover, plenty of financial institutions offer HSA CDs.
When you open these CDs, you'll make your initial deposits on a pre-tax basis. Moreover, you won't pay taxes on the growth as long as you use the money to cover qualified health-related expenses. These include prescriptions, doctor fees, vaccines and more.
Why now is a great time to open a CD
Whether or not you can avoid taxes on the interest you earn when you open a CD, this may be a great time to open one. Here's why:
- High interest rates: Interest rates are high at the moment, resulting in strong CD returns. That's largely the result of the Federal Reserve raising its target federal funds rate several times over the past couple of years to combat inflation. However, many expect rates to fall relatively soon as inflation cools. So, you may not be able to tap into high CD returns much longer.
- Fixed returns: When you open a CD, you'll earn a guaranteed APY for the entire account term. That means when you open a CD now, you'll lock in today's high interest rates. So, even if rates do fall as expected, you'll continue to earn a consistent return for the entire CD term.
- Safety: CDs are generally safe investment vehicles. Not only are they usually FDIC- or NCUA-insured, but they offer fixed returns that aren't susceptible to the ebbs and flows of the financial market or the overall economy.
The bottom line
You can cut down on the taxes you pay on the interest your CD earns by opening it as part of a tax-advantaged account. However, that's not always a feasible option. After all, you may not want to wait to access your money until you're retired and you may have already tapped out your HSA or 529 savings plan limits. Even if a tax-advantaged CD doesn't make sense, it may be wise to open a traditional CD quickly. After all, if you wait too long to tap into one, you could miss out on today's high rates.
