If you inherit or plan to bequeath a certificate of deposit (CD) as part of your estate, there may be tax consequences to consider. Three kinds of taxes could apply: income, estate and inheritance. While the principal amount of the CD transfers without income tax issues, any interest earned after death and before transfer will be treated as ordinary income on the tax return of the person who inherits it. Federal estate taxes won’t apply unless the size of the estate, including the CD, exceeds the generous federal exemption, and there is no federal inheritance tax to be paid by the heir. Several states have inheritance and estate taxes, and these generally have much lower thresholds for exemption, so they may come into play. Setting up the CD to transfer on death will help avoid probate, but won’t affect taxes. Let’s take a closer look at the tax consequences of inheriting a CD.

If you have questions, consider asking a financial advisor for help preparing your estate plan or handling any potential taxes on an inherited CD.

CD Inheritance Basics

A CD is a fixed-income savings tool offered at many banks and credit unions. It allows a saver to set aside a specific amount of money for a specific length of time ranging from weeks to years and, in return, earn a pre-set rate of interest. Federal deposit insurance makes CDs as safe as anything you can do with your money. However, CD interest rates, while often higher than a savings account, are likely to lag behind inflation. And there may be a penalty if you withdraw money before the end of the term.

Many savers and investors appreciate CDs for their safety and convenience. They may well be part of your estate. Or, if you’re going to inherit a CD from someone, you may be faced with the potential tax consequences. CDs can present tax complications depending on factors such as the size of the CD and where the deceased and heir reside.

Inherited CD Tax Considerations

Three types of taxes may come into play when you’re looking at the tax consequences of inheriting a CD: income, estate and inheritance taxes. The first of these is the one most likely to be encountered, but likely won’t be a major cost. The second may be relevant, but probably only to a small number of cases. The third is least likely and will be the responsibility of the heir who receives the bequest.

Income Tax

The IRS does not regard the value of an inherited CD as taxable. That is, if you receive a $10,000 CD, you won’t have to increase your reported income by $10,000. The interest on the CD is another matter, however. Interest earned before the deceased’s death is not considered income to the recipient of the CD. However, income earned by the deposit after the death is regarded as ordinary income taxable at the recipient’s usual tax rate. Because of the relatively modest interest rates paid by many CDs, the tax bill on interest earned is unlikely to be much except in the case of an unusually large CD inheritance.

It is worth noting that many banks will waive the early withdrawal penalty if the inheritor of a CD wants to withdraw funds before the term of the deposit is up. And, if the bank does charge a penalty on an inherited CD, the recipient of the bequest can likely deduct the amount of the penalty from taxable income for that year.

Estate Tax

Tax law does provide for federal estate taxes on inherited assets, but the tax only applies to estates over a certain amount. Currently, that amount is $13.61 million, so it’s only relevant to relatively few estates. There is no federal inheritance tax.

A handful of states also have estate taxes. Some use the same floor as the federal estate tax for their levies. However, a few have much lower thresholds. Oregon, for example, taxes estates over $1 million.

Inheritance Tax

A similarly small number of states have inheritance taxes, which the recipient of the bequest has to pay. Only Maryland has both estate and inheritance taxes. Generally speaking, due to their overall rarity and the use of thresholds below which taxes don’t apply, estate and inheritance taxes will not be concerns for most estates or heirs.

Transfer on Death

Some CD owners set them to transfer ownership automatically to a beneficiary on the owner’s death. This can be an effective way to avoid having the CD pass through probate, a process likely to add months or years to the time required to distribute funds to heirs, as well as incurring extra costs. However, transfer on death arrangements won’t affect inheritance or estate taxes on an inherited CD. Nor will they have any effect on taxes that could be due on post-death interest earned.

Bottom Line

Passing on a CD as part of an estate involves no major tax consequences in most situations. The most likely tax is the income tax that will be due on interest earned after the death of the person making the bequest. This tax will be paid by the inheritor of the CD. Federal estate taxes only apply on particularly large estates, and most states don’t have estate taxes. There’s no federal inheritance tax, and most states don’t tax heirs, either. However, some states have estate taxes with significantly lower thresholds than the federal level, and at least one state has both estate and inheritance taxes.

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