A:

Certificates of deposit (CDs) are popular savings vehicles for investors who are seeking a steady return that is not tied to stock market performance. A CD is typically issued by a bank or credit union and offers an interest rate on deposited funds in return for leaving that money in the account for a specific term, commonly one, three or five years. Although a CD is considered a safe investment, individuals need to be aware of how taxes may impact total return.

Interest earned on a CD may be paid to another account or it can be reinvested in the total balance. Regardless of how the interest is credited back to the investor, it is considered taxable for both state and federal tax purposes. The bank or credit union that issued the CD provides the owner of the account with a 1099-INT statement at the end of every year detailing how much interest was earned, and that amount is taxed as interest income, not at the lower capital gains. If an investor is in a 25% tax bracket and has earned $300 in CD interest for the year, he or she owes $75 in taxes for interest earned that year.

Some individuals may use a CD as a retirement savings vehicle by depositing funds into an IRA certificate. In this case, the same rules of tax deferral that apply to an IRA are applied to the CD. Although interest is being earned, no 1099-INT is issued until distributions are taken from the IRA during retirement.

A CD may be an appropriate investment for individuals looking for stability and steady growth on funds, but it is important to understand how taxes applied to interest earned may dilute total return.

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