CD Interest, Bank 1099-INT Forms and Taxes

I first published this article several years ago. I thought this would be a good time to refresh this article as savers prepare their tax returns. Unless you hold a CD in an IRA or other retirement account, you have to pay taxes each year on the interest earned from a CD.

Interest from a CD is taxable whether the CD is from a bank or credit union. At credit unions, a CD is often called a share certificate and interest is often called dividends, but from the IRS perspective, there is no difference between interest from a bank CD or dividends from a credit union share certificate.

The bank or credit union should send you the Form 1099-INT by January 31st which lists the interest earned during the previous year. Institutions don’t have to send them if interest earned is under $10. Also, you may not receive a paper Form 1099-INT in the mail if you accepted your bank’s account agreement for receiving bank documents (including Form 1099-INT) electronically.

My original article focused on the question about what years during the term of a CD should you expect to receive Form 1099-INT from your bank. This updated article will also help you understand how much interest earned for a particular year will be listed in Form 1099-INT and how early withdrawal penalties are included. My source for the answers is the IRS Publication 550.

Interest is Taxable Whether It’s Paid Out or Reinvested

The first important thing to understand is that from a tax point-of-view, it doesn’t matter if interest is added back to the principal of the CD or paid out to you by check or ACH. In either case, it’s considered taxable interest. For those new to CDs, this might be an unpleasant surprise if you had thought you wouldn’t be paying taxes on a CD when you didn’t receive an interest payment.

When Taxes Are Owed on CD Interest

Taxes will be owed for the years when interest is paid by the CD. The IRS Publication 550 describes the limits of when banks can pay interest on CDs:

Certificates of deposit and other deferred interest accounts. If you buy a certificate of deposit or open a deferred interest account, interest may be paid at fixed intervals 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.

First, note that interest is to be paid “at fixed intervals of 1 year or less.” Thus, there will be yearly interest to report for CDs with multiple-year terms. There will not be just one payment of interest at maturity. The first payment of interest may be delayed up to one year from account opening. For example, if you opened a 3-year CD today and the CD only pays interest on yearly intervals from the day the account was opened, you will not have interest paid this year, and thus, you will not receive Form 1099-INT for this CD next January. However, if the CD pays interest monthly and you open the CD before December, you should expect to receive Form 1099-INT for this CD next January.

Second, note that for CDs with terms of one year or less, interest can be paid in a single payment at maturity. Thus, if you open a 1-year CD today and the CD only pays interest at maturity, you won’t have any taxable interest on that CD for this year, and you shouldn’t expect to receive Form 1099-INT for this CD next January.

Some banks allow you to specify the intervals of when interest will be paid. For example, if you open a CD at Ally Bank with a term of one year or less, the default will be for interest to be credited to your CD at maturity. Customers also have the option to change payment to be done monthly, quarterly or annually. If you choose these other intervals for a 1-year CD, you may have taxable interest for two tax years.

Original Issue Discount (OID) and CDs

There’s a complication when a CD has a term of over one year and the bank chooses to pay interest only at maturity. The last sentence of the above excerpt references the section on Original Issue Discount (OID). The OID section of Publication 550 defines OID as follows:

OID is a form of interest. You generally include OID in your income as it accrues over the term of the debt instrument, whether or not you receive any payments from the issuer.

More details on OID specific to CDs are provided in the next page of the OID section:

If you buy a CD with a maturity of more than 1 year, you must include in income each year a part of the total interest due and report it in the same manner as other OID.

So if the bank doesn't pay interest until the CD matures and the CD term is over one year, the bank should send out the Form 1099-OID and the CD account holder must include this "phantom interest" or "imputed interest" in his or her income each year.

One well-known exception to reporting OID is the U.S. savings bond. This is the second example of exceptions listed in the OID section. You don't have to worry about reporting savings bond interest until you redeem the savings bond or until it reaches maturity after 30 years. That's one nice advantage that savings bonds have over CDs.

How Early Withdrawal Penalty Affects Taxes Owed

In addition to interest income, Form 1099-INT can include an early withdrawal penalty. There are separate boxes on Form 1099-INT for both interest and an early withdrawal penalty. In most cases, when you withdraw principal from a CD before it matures, the bank will charge you an early withdrawal penalty. The Publication 550 provides the following instructions on reporting early withdrawal penalties:

The Form 1099-INT or similar statement given to you by the financial institution will show the total amount of interest in box 1 and will show the penalty separately in box 2. You must include in income all interest shown in box 1. You can deduct the penalty on Form 1040, line 30. Deduct the entire penalty even if it is more than your interest income.

It might seem strange that an early withdrawal penalty (EWP) can be more than the interest. This can occur if the early withdrawal is done early in the term of a CD. For example, if the EWP is equal to six months of interest and you close the CD three months from the date it was opened, the EWP will be twice the amount of the interest. Another way an EWP can be larger than the interest on the 1099-INT is if interest from the CD was reported in previous tax years. Not much interest may have been paid in the tax year when the EWP occurred.

Taxes on Savings and Money Market Account Interest

As you can see from above, interest reporting on a CD has a few complications. Interest reporting on a savings, checking or money market account is more straightforward. For these types of liquid bank accounts, there are typically no early withdrawal penalties. Second, interest is typically paid monthly. So you should expect to have interest income for the years you own a liquid bank account. The only exception would be if you opened the account in December. If the bank pays interest on monthly intervals starting a month from the opening date, no interest might be paid in that year.

This article contains general information and should not be considered tax advice. If you have a question about your taxes, and what should be reported on them, it is a good idea to consult a tax professional who can help you navigate the rules.