When the certificate of deposit is held in a taxable account -- i.e., not a retirement account, education account or health savings account that receives tax deferral -- the interest is taxable as ordinary income in the year in which you receive it. The bank will issue you a 1099-INT, detailing the amount of interest you received. It forwards this information to the IRS, as well. You must claim this interest on your individual income tax return.
If the CD is held in a tax-deferred account such as an individual retirement arrangement, different rules apply. In this case, you do not need to pay income tax on interest the CD earns. The interest compounds within the IRA until you withdraw it. When you take a withdrawal or distribution, the IRS charges income tax on the entire withdrawal amount. However, if you bought the CD with nondeductible IRA contributions, the IRS allows you to recover your own contributions you made with after-tax dollars.
IRAs and Early Withdrawals
The IRS charges a 10 percent penalty on IRA withdrawals prior to the age of 59-1/2. This is also true for CDs held in IRA accounts. To avoid this penalty, either wait until you are 59-1/2 or make the withdrawal for a permissible reason: because of a disability, to pay medical bills, to make a down payment of up to $10,000 on a home for yourself or your family, to fund educational expenses, or as a series of equal periodic payments made over your life expectancy or the joint life expectancy of you and your spouse or other loved one.
If you are looking for a safe place to put money, you may also consider money market accounts. These perhaps provide a slightly higher interest rate, but do not have FDIC protection. For longer-term savings, you may consider a fixed annuity -- especially for retirement planning. Other alternatives include equity indexed annuities and dividend-paying whole life insurance. Annuities provide tax deferral on growth, while cash value growth in life insurance policies is tax free. And municipal bonds can provide tax-free income, though there is no FDIC insurance on these bonds. They are subject to default risk.