What Is a Certificate of Deposit (CD)? How CDs Work

By
Harris
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25

Key Points

  • A certificate of deposit (CD) holds a fixed amount of money for a fixed term, such as six months, one year or five years, and the bank pays interest in return.
  • CDs are deposits, so a CD at an FDIC-insured bank is covered up to $250,000 per depositor, per bank, per ownership category, counted together with your other deposits there.
  • Taking money out before maturity usually costs an early withdrawal penalty; federal Regulation D sets a floor of seven days’ simple interest in the first six days.
  • Under Regulation DD, a bank must tell you before maturity when a CD longer than one month will renew automatically, generally at least 30 calendar days ahead.
  • CD interest is taxable in the year it is credited and available to you, and an early withdrawal penalty can be deducted on Schedule 1 of Form 1040.

A certificate of deposit, or CD, is a savings account with a deal attached: you agree to leave a set amount of money with a bank or credit union for a set period, and in exchange the institution pays you interest. When the term ends, on what is called the maturity date, you get your original deposit back plus the interest it earned.

The trade-off is access: money in a CD is meant to stay put, and pulling it out early usually costs you. Here is how a certificate of deposit works, what the bank must disclose, what happens at maturity and how the interest is taxed, based on federal rules and IRS guidance.

What is a certificate of deposit?

According to Investor.gov, the SEC’s investor education site, a CD “holds a fixed amount of money for a fixed period of time, such as six months, one year, or five years, and in exchange, the issuing bank pays interest.”

Federal banking rules call this kind of product a time account or time deposit. Regulation DD, the rule that carries out the Truth in Savings Act, defines a time account as one with a maturity of at least seven days in which the consumer generally does not have a right to make withdrawals for six days after opening it, unless an early withdrawal penalty applies.

Credit unions offer the same product, often called a share certificate.

How a CD works, step by step

1. You choose a term and make a deposit

You pick how long the money will be tied up and deposit a lump sum.

2. The bank sets the rate

The bank tells you the interest rate and the annual percentage yield (APY). The APY reflects how often interest compounds over a year, which is why it can be slightly higher than the stated rate. Our explainer on how APY differs from APR walks through that math with examples. Many CDs pay a fixed rate for the full term, but some pay a variable rate, and the disclosure must say which one you have.

3. Interest accrues during the term

Interest may be credited monthly, quarterly, annually or at maturity, depending on the account.

4. The CD matures

At the end of the term you can withdraw the money, move it elsewhere or let it roll into a new CD. If you do nothing, your renewal terms decide what happens.

As a simple hypothetical, a $10,000 deposit in a one-year CD with a 4.00% APY would earn about $400 if held to maturity. If the same 4.00% APY applied for five years and the interest stayed in the account, the balance would grow to about $12,167. These figures illustrate the math only and are not current rates.

What the bank must tell you before you open a CD

Regulation DD requires written account disclosures. Under 12 CFR 1030.4, for a CD the bank must state, among other things:

  • The interest rate and the APY, using those terms, and for fixed-rate accounts how long the rate will be in effect
  • How often interest compounds and is credited
  • Any fees and when they apply
  • The maturity date
  • Whether a penalty will or may be imposed for early withdrawal, how it is calculated and when it applies
  • Whether the account renews automatically at maturity and, if so, whether there is a grace period and how long it lasts

Investor.gov adds that the disclosure should say when interest is paid, for example monthly or semi-annually, and whether by check or electronic transfer.

Early withdrawal penalties

Federal rules set only a minimum penalty. Under the Federal Reserve’s Regulation D, 12 CFR 204.2, a time deposit that allows withdrawals within six days of the deposit must charge a penalty of at least seven days’ simple interest on the amount withdrawn in that window. Beyond that floor, each bank sets its own penalty.

Penalties are commonly expressed as a number of days or months of interest. As a hypothetical, if a bank’s penalty were 90 days of simple interest on a $10,000 CD paying 4.00%, the penalty would be about $98.63.

What happens when a CD matures

Many CDs renew automatically into a new CD of the same term at the bank’s rate at that time. Regulation DD defines a grace period as the window after maturity of an automatically renewing account during which you can withdraw funds without a penalty.

For automatically renewing CDs with a maturity longer than one month, 12 CFR 1030.5 requires the bank to send renewal disclosures before maturity. The notice must be mailed or delivered at least 30 calendar days before the existing CD matures. Alternatively, the bank may send it at least 20 calendar days before the end of the grace period, provided the grace period is at least five calendar days.

For CDs longer than one year, the notice must include the full disclosures for the new CD and the existing CD’s maturity date. If the new rate is not yet known, the bank must say when it will be set and give a phone number to get it.

Common types of CDs

Features differ by institution, so these are general descriptions, not standard terms.

Type How it generally works What to check
Traditional CD Fixed rate, fixed term, penalty for early withdrawal Penalty formula and renewal terms
Variable-rate CD Rate can change during the term based on a stated method How and how often the rate changes
No-penalty CD Allows withdrawal after an initial period without a penalty When withdrawals are allowed and the rate trade-off
Callable CD The issuer can end the CD before maturity Call dates, and how long the money could actually be tied up
Brokered CD Bought through a brokerage or deposit broker rather than directly from the bank The issuing bank, insurance coverage and how to sell before maturity

Investor.gov warns that deposit brokers are not licensed or certified and that no state or federal agency approves them, so check the broker and the issuing bank, including through the SEC’s and FINRA’s online databases.

How safe is a CD?

Because a CD is a deposit, it is covered by federal deposit insurance when it is held at an insured institution. The FDIC lists certificates of deposit among the deposit products it insures, alongside checking, savings and money market deposit accounts. The FDIC does not insure stocks, bonds, mutual funds, crypto assets, annuities or U.S. Treasury bills, bonds and notes.

Coverage is up to $250,000 per depositor, per insured bank, for each ownership category. The FDIC adds together all your deposits in the same ownership category at the same bank, regardless of type, so a CD and a savings account in your name alone share one $250,000 limit. Our guide to how the FDIC’s $250,000 coverage works explains ownership categories, joint accounts and trust accounts in detail. Credit union share certificates are covered separately by the National Credit Union Administration’s insurance fund.

Insurance protects you if the bank fails, but not against every risk. Investor.gov names inflation: if prices rise faster than your yield, your money loses purchasing power. And if rates rise after you lock in, a fixed-rate CD keeps paying the older rate until maturity.

How CD interest is taxed

CD interest is generally taxable as ordinary interest income. The IRS lists interest on certificates of deposit among its examples of taxable interest in Topic No. 403. If you received $10 or more in interest, the bank should send you Form 1099-INT, but you must report all taxable interest even if you do not receive a form.

IRS Publication 550 says interest on a CD is generally included in income when you actually receive it or are entitled to receive it without paying a substantial penalty. That rule also covers CDs of one year or less that pay all interest at maturity. If interest on a CD is deferred for more than one year, the original issue discount rules may apply instead.

If you pay an early withdrawal penalty, Publication 550 says you must still report the full interest shown in box 1 of Form 1099-INT. The penalty appears separately in box 2, and you can deduct it on Schedule 1 of Form 1040.

Is a CD right for your savings?

A CD tends to fit money you will not need for a known period, such as savings for a purchase a year or two away. It is a poor fit for an emergency fund, because of the penalty for early access.

Some savers build a CD ladder to balance access and yield. As a hypothetical, instead of putting $10,000 into one five-year CD, a saver could split it into five $2,000 CDs maturing in one, two, three, four and five years. Each year one CD matures, giving access to part of the money and the option to reinvest it.

Before opening a CD, compare the APY, read the penalty formula, note the maturity date and renewal terms, and confirm the bank is FDIC-insured or the credit union NCUA-insured. For the latest on interest rates and the Federal Reserve, follow our Markets Live center, and for major national stories, the LiveNewsWorld U.S. News Live center.

The bottom line

A certificate of deposit trades flexibility for predictability: you leave money untouched for a set term, and the bank pays a stated rate. Federal rules require clear disclosures of the rate, APY, maturity date, penalty and renewal terms, plus advance notice before an automatic renewal. CDs at insured banks are covered up to the FDIC’s $250,000 limit, and the interest is taxable when it becomes available to you. This article is for general education and is not financial or tax advice.

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