​​Don't Make These 3 Common Expensive Mistakes With Your CDs

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Certificates of deposit (CDs) are FDIC-insured and generally safer than investing in stocks and ETFs. What’s more, with CD rates hitting levels we haven’t seen in over two decades, you could earn a hefty amount of interest with one of today’s top-paying CDs.

That said, CDs aren’t totally risk free. While FDIC insurance will cover your deposits up to $250,000, you can make some common mistakes that hurt your CD earnings. You might know about early withdrawal penalties (which can cost you an arm and leg if you cash out your CD before it matures), but here are three other little-known errors that could cost you money.

1. Neglecting taxes

Like interest earned on other bank accounts, CD interest is taxed at both the federal and state level. If you have a short-term CD that matures in the same year you opened it, you’ll report your CD interest on your tax return for that year. Likewise, for long-term CDs, like those with 2-year terms, you’ll report the interest you earn each year, even if you didn’t withdraw or use it.

It’s important to set money aside to cover these taxes so you’re not left with a bigger tax bill than what you were expecting. Since CD interest is taxed at your ordinary tax rate, it would be prudent to set that percentage aside for tax purposes. For instance, if you’re in the 22% tax bracket, set aside 22% of your CD interest for taxes. Even if tax deductions and credits reduce your effective tax rate, you’ll still cover your bases.

Pro tip: Put the money you set aside for CD taxes into a high-yield savings account. That way, you can earn a little extra on money earmarked for taxes. Just be sure to factor in taxes for this interest, too, as savings accounts follow the same tax rules as CDs.

2. Cashing in on your interest

While banks generally don’t let you withdraw your initial deposit without paying a penalty, some will let you cash in on the interest you’ve earned. Often, CD providers will credit the interest periodically to your account (for example, monthly or annually) after which you can transfer it to a checking account penalty-free.

Withdrawing CD interest early could help you meet your monthly budget or avoid liquidating your CD account early to cover an emergency expense. But since CDs grow by compound interest, any withdrawal will slightly reduce your CD’s stated APY. If you can help it, try to keep as much money in the pot as possible, so as to increase your overall returns.

3. Misunderstanding APY

CDs are advertised by their annual percentage yield (APY), which is how much interest your CD will generate within a year. This assumes you keep your CD contract intact (no early withdrawals) and also don’t withdraw interest (if your CD allows for it).

While APY can help you calculate your overall returns, be sure you understand that the returns are annualized. For example, if you deposit $10,000 into a 3-month CD with a 5.30% APY, you won’t earn $530 in interest. You would if your CD term was 12 months. But since it’s three months, you’ll generate roughly $130.

In addition to these three errors, you might also leave money on the table by neglecting to shop around for CDs before locking into one. The truth is, many CD rates aren’t as competitive as the issuing bank or financial institution makes them seem. True, the CD rate may be several times higher than the national average, but if it’s not also as high as other rates for that respective term, you could be missing out on more interest. Take a moment to compare top-paying CDs for different terms and lock into one that truly gives you the best bang for your buck.

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