A: The short answer is you can’t avoid paying taxes on the interest you earn on the certificate of deposit. And frankly, you shouldn’t try. If you earn the interest, you are obligated to pay taxes on that money.
If you recall, scripture says, in Matthew 22:21: “Then he said to them, ‘Give back to Caesar what is Caesar’s, and to God what is God’s.’” (Today’s New International Version.) In other words, pay back to the government what it says you owe. You can find information about the interest you earned on the 1099-INT that your financial institution should send you.
But, depending on how long you have to hold that money in a CD, how much are we really talking about? CD rates are pretty low these days. A five-year CD is paying less than 2%, according to the national average reported by Bankrate.com. In a year, you might earn roughly $500 in interest income on the CD.
Your interest income is taxed at your marginal tax rate. This is the rate of the highest tax bracket you fall into. So, if you’re in the 35% tax bracket, your interest income will be taxed at 35%. That means that you’re looking at a tax bill of about $175 on the interest income. That’s hardly enough to try and mess with the IRS and risk penalty and fees.
But, you could reduce your tax liability by getting help from a good tax professional. You may be able to reduce your overall tax bill, depending on any deductions and credits you are entitled to receive.