Identification

• A CD is an FDIC-insured bank deposit. As of 2010, the FDIC insures $250,000 worth of deposits per customer, per bank. Beyond the FDIC coverage, think of your certificate of deposit as a loan to the bank. In exchange for making the loan, you collect interest payments until your principal is repaid at maturity. Interest payments typically increase when you loan money to the bank for extended periods. For example, a one-year CD should pay out a higher interest rate than a one-month CD.
  
  

Ordinary Income Taxes

• Certificate of deposit interest payments are taxed as ordinary income in the tax year that they occur. If you close out a CD before its maturity date, you may be able to deduct the resulting bank penalties from your taxable income.
  
  As of 2010, ordinary income tax rates are 10, 15, 25, 28, 33, and 35 percent. U.S. tax law is progressive, which means that high-income filers pay the highest tax rates. With a single or married filing jointly status, your CD interest will be taxed at a 35 percent rate when your annual taxable income exceeds $373,650. Alternatively, single and married filing jointly taxpayers who report less than $8,375 and $16,750 in taxable income, respectively, are taxed at the 10 percent ordinary income rate.
  
  

Tax Paperwork

• At tax season, the bank will prepare Form 1099-INT for both you and the IRS. The 1099-INT summarizes your bank deposit interest payments over the past year. To verify the information, compare the 1099-INT totals against your monthly CD statements. Use the 1099-INT data to complete your 1040 personal income tax form. Report the CD interest as part of your taxable interest income directly on the 1040.
  
  

Strategy

• With financial planning, your ultimate goal remains to make the most money for the level of risk that you are willing to accept. Balancing risks versus reward does not always translate into saving money on taxes. For example, you might consider taking out a CD as part of an IRA to bypass paying taxes on CD interest earnings as they occur within the retirement account. Putting a CD into an IRA, however, might jeopardize your retirement plan because CDs offer relatively small returns. Over the long term, you might be better served to invest in stocks for the IRA, while taking out regular bank-offered CDs as taxable accounts.