The banking CD, or certificate of deposit, is a simple but helpful way to create financial security for the future. As a money market instrument, the interest rate earned on a banking CD is based on current money market rates. Many consider the bank certificate of deposit one of the safest investment opportunities available today.
Setting up a banking CD involves depositing money in a particular account with a banker. This deposit stays in the account until a pre-determined maturity date is reached. In exchange for leaving the money in the CD account until maturity, the bank applies a specific or fixed interest rate to the deposited funds. It is possible to create a banking CD with a term of between one and five years.
Most banks will impose severe penalties if the depositor chooses to withdraw funds from the CD account before the due date. Sentences are often enough to offset the returns that would have been realized if the banking CD had remained in place until maturity. This process encourages investors to leave the banking CD unless an emergency arises.
Once the maturity date is reached, investors have several options. One option is to transfer the accrued interest to a savings or checking account and renew the CD for another period. The second approach is to reinvest principal and interest for another interest-bearing period. Finally, the investor can receive both principal and accrued interest in cash or as a funds transfer to an existing account. It is essential to remember that taxes are usually due on any funds generated from the banking CD and possibly on the principal if that balance has been used as a deduction in previous years.
Banks and investors can benefit from creating a banking CD rather than simply depositing the funds into a standard savings account. Since there is a maturity period that allows the bank to use these funds for an extended period, banking CD rates are usually higher than the amount of interest that can be earned with a savings account. Banks are given reasonable assurance that funds will remain in possession of the bank for an extended period. At the same time, a depositor can withdraw funds from a savings account at any time.
A banking CD is a much better option than a savings account for anyone who has a sum of money that will not be needed for the foreseeable future and wants to earn a higher interest rate. Although they do not generate returns comparable to bonds or stock options, banking CD rates offer a decent return with a much lower level of risk. This makes the banking CD an attractive savings tool for people who are very conservative with their money.
How does a banking CD work?
Opening a banking CD is similar to opening a standard bank deposit account. The difference is what you agree to when you sign on the dotted line (even though that signature is now digital). After going around the market and identifying the banking CD(s) you will open, the procedure will lock you into a quadruple circle.
Interest rate: Locked-in rates are a plus in that they provide a transparent and predictable return on your deposit for a given period. The bank cannot change the rate later, reducing your income. On the other hand, a fixed yield can hurt you if rates rise significantly afterwards and you have lost the opportunity to take advantage of higher-paying bank CDs.
The Term: This is the period you agree to leave your funds deposited to avoid any penalties (e.g. six month CD, one-year CD, 18-month CD, etc.) The term ends on the “date Maturity” when your banking CD has fully matured, and you can withdraw your funds without penalty.
Principal: Except for certain specialized CDs, this is the amount that you agree to deposit when the CD is opened.
The institution: The bank or credit union where you open your banking CD will determine aspects of the deal, such as early withdrawal (EWP) penalties and whether your banking CD will be automatically reinvested if you don’t give further instructions. At the time of maturity.
Once your banking CD is set up and funded, the bank or credit union will operate it like most other deposit accounts, with monthly or quarterly statement periods, paper or electronic statements, and usually interest payments. Monthly or quarterly deposits will compound interest on your CD balance.
How is income from Bank CDs taxed?
When you hold a bank CD, the bank regularly charges interest on your account. This transaction is usually monthly or quarterly and will appear on your account statements as earned interest. Just like interest paid on a savings or money market account, it will accrue and be reported to you in the new year as interest earned, so you can report it as income when you your tax return.
Sometimes people need clarification because they cannot withdraw and use these interests. They, therefore, expect to be taxed on this income when they start the funds from the bank CD at maturity (or sooner if they cash them in early). This is not the case. For tax reporting purposes, your bank CD earnings are taxed when the bank allocates them to your account, regardless of when you withdraw your bank CD funds.