Using Early Withdrawal Penalties as Income Tax Deductions

Certificates of Deposit (CDs) are fixed for a specific term and often fetch a higher interest rate than a standard savings account, but if they're cashed in before they mature, you could be hit with a penalty. The good news is that penalty is tax deductible.

The Deduction

When you cash in your CD early, you're often charged a penalty. This is usually a certain amount of the interest forfeited and even a possible cut taken out of your initial principal deposit. The full penalty is tax deductible.

If you're dealing with savings certificates that have fixed maturities (longer than a year), your tax deduction is based on your forfeiture of interest.

Limits on these Deductions

There are no limits on early withdrawal penalty tax deductions.

Conditions

There are no conditions to meet. The only requirement is that you pull funds out of a CD or savings certificate before the maturity date and subsequently incur a penalty. That penalty is then tax deductible.

Plan Ahead for This Deduction

This tax deduction is a kind of worse-case scenario. Ideally, you want to see your funds stay in a Certificate of Deposit (CD) until they reach maturity and without incurring any penalties. In order to do that, avoid socking money away for longer than when you think you may need the funds.

Alternatively, split your savings into multiple accounts with different maturity dates. This will give you access to funds on a regular basis without incurring fees.

Penalties Can't Be Netted Against Interest

You can't use the penalty against the interest you may have earned on a CD. Instead, you must report the income earned, if any, separately from the withdrawal penalty deduction.

Where to Make the Deduction

If you're deducting an early withdrawal penalty on your income taxes, use Form 1099-INT if the CD is less than a year old. If it's older, use Form 1099-OID. You should receive these forms from the bank issuing the Certificate of Deposit. The amount on this form can then be deducted from your Adjusted Gross Income on Form 1040.