If you open up a certificate of deposit, or CD, at your bank, you may earn a higher rate of interest than with a traditional savings account. Unlike most savings accounts, pulling money out of your CD early may come with penalties. But regardless of whether you leave the money in your CD until it matures or you pull it out early, only the interest portion is considered taxable income.

How CDs Work

To open up a CD account, it generally requires a one-time deposit that's supposed to remain in the account until the CD's maturity date -- the day you can withdraw all of the money deposited and the accrued interest without penalty. Financial institutions offer CDs with various maturity dates, which can be six months, one year, three years, five years or even longer. For example, if you deposit $10,000 into a one-year CD that pays 3 percent interest, the maturity date is one year from the day you make the deposit. On this day, you'll get your $10,000 back plus $300 for the accrued interest. If your financial situation changes, and you need to pull the money out of the CD early -- which is any withdrawal you make prior to the CD's maturity date -- the financial institution may penalize you by paying you less interest.

Taxable Interest Income

For tax purposes, it doesn't matter when you actually withdraw the money from your CD. You always recover your initial deposit tax-free -- meaning it isn't considered taxable income. The interest you earn, however, is always taxable income in the year it's credited to your CD account. To illustrate, suppose you opened that aforementioned one-year CD on July 1, 2013. At the end of the 2013 tax year, you'll report six months of interest, or $150, as taxable income on your return and the remaining $150 of interest on your 2014 return.

Tax Implications of Pulling Money Out Early

Because the Internal Revenue Service taxes interest as it accrues in your CD account during the year, the tax implications are the same regardless of whether you leave the money in the account until the maturity date or withdraw it early. Withdrawing the funds early may, however, reduce the amount of interest you'll report, which can ultimately save you money in tax. Moreover, your initial deposit remains nontaxable -- the IRS doesn't penalize you for withdrawing it early. At the close of each tax year, your financial institution will send you a Form 1099-INT that reports the amount of taxable interest you earned. It isn't necessary to send Form 1099-INT to the IRS with your return, rather you'll just transfer the amount of “Interest income” reported in box 1 to the appropriate line of your tax return, though your 1099-INT may include other important tax-related information to report as well.

Early Withdrawal Penalty Deduction

If you do pull money out of a CD early, the 1099-INT you receive that year may report an “Early withdrawal penalty” in box 2. Your interest income -- reported in box 1 -- includes the penalty, or forfeited interest rather, in box 2. To avoid paying tax on forfeited interest, the IRS lets you take a deduction for the early withdrawal penalty as an adjustment to income -- a deduction that reduces your total income to arrive at your adjusted gross income.