When you purchase a certificate of deposit or time deposit, you normally start to earn interest on the account from the time that the issuer opens the CD. You have to pay tax on the interest that you earn on your CDs, although the term of the account dictates whether you pay taxes on accrued interest vs. received interest.
The accrued interest on a CD represents the amount of interest that you have earned to date, although you do not typically receive the interest until the CD term ends. If you have a CD with a term of 12 months of less, you do not report the earnings until you receive the interest. So you pay taxes in the year you receive the money even if you actually accrued most of the interest during the prior year. If applicable, you also have to pay state taxes on the money in the year you receive it.
Original Issue Discount
If you buy a CD with a term longer than 12 months, then the CD issuer may opt to make annual interest disbursements. In this case, you pay taxes on the money as you receive it. If the issuer does not make annual interest disbursements then the issuer has to provide you with an original-issue-discount 1099 form. This form details the amount of interest that you accrued but did not receive during each year of the CD term. You must pay taxes on an annual basis based upon the interest as shown on the OID 1099 even though you only actually receive the interest at the end of the CD term.
Some financial institutions sell market-linked CDs which pay a return based upon the performance of the stock market over a multi-year period or on the performance of indexes like the Dow Jones Industrial Average. In many instances, you only make any money if the index rises during the CD term. However, since you have to pay taxes during the CD term, the issuer estimates your probable return and issues an OID 1099 that includes those estimates. You pay taxes based on the OID 1099 but have to file a tax amendment when the CD matures if your actual returns are greater or lower than anticipated.
Tax qualified accounts are accounts that grow tax-deferred, such as individual retirement accounts or accounts holding pension money. With a tax qualified account you neither pay taxes based upon your accrued interest nor on the interest the CD issuer paid. Instead, your earnings remain inside the tax-qualified account and continue to grow tax sheltered until you make a withdrawal. At that time, you pay ordinary income tax on the money that you withdraw from the account. You also pay a 10 percent federal tax penalty if you withdraw the money before you are 59 1/2, although the federal government does not charge this penalty fee if you need the money for certain expenses, such as college tuition.