If you withdraw money early from a certificate of deposit (CD) or certain interest-bearing savings accounts, your bank may charge an early withdrawal penalty. While that penalty reduces the amount you receive from the account, it may also qualify for a deduction on your federal tax return.
Understanding how the penalty is reported and entered in your tax return can help you avoid errors and claim the deduction you're entitled to.
What Is an Early Withdrawal Penalty?
An early withdrawal penalty is a fee charged by a bank or financial institution when you withdraw funds from a CD or other time-deposit account before it matures.
In most cases:
- The penalty represents interest you must give up.
- In some situations, it may reduce part of your principal balance.
- The penalty is charged by the financial institution, not by the IRS.
The amount of the penalty depends on the terms of your account agreement.
Where Is the Penalty Reported?
If you paid an early withdrawal penalty, your bank will typically report it on one of these tax forms:
Form 1099-INT
- Box 1: Interest income earned
- Box 2: Early withdrawal penalty
Form 1099-OID
- Box 3: Early withdrawal penalty
Important: You must report all interest income shown on your tax form, even if some or all of that interest was forfeited because of the penalty.
This Is Different From an Early Retirement Withdrawal Penalty
An early withdrawal penalty on a savings account or CD is not the same as a penalty for withdrawing money from a retirement account, such as an IRA or 401(k).
These penalties have different tax rules and are reported separately on your tax return.
How Is the Penalty Treated on Your Tax Return?
The IRS allows you to deduct an early withdrawal penalty as an adjustment to income.
This deduction:
- Is reported on Schedule 1 (Form 1040)
- Reduces your Adjusted Gross Income (AGI)
- Can be claimed even if you do not itemize deductions
- Is allowed even when the penalty is greater than the interest earned
Because it reduces your AGI, the deduction may also affect eligibility for certain tax benefits and credits.
Example
Suppose you cash out a CD before it matures and receive the following Form 1099-INT:
- Interest earned (Box 1): $300
- Early withdrawal penalty (Box 2): $450
Here's how it is reported:
- Report the full $300 as interest income.
- Claim the full $450 early withdrawal penalty deduction on Schedule 1.
Even though the penalty exceeds the interest earned, the entire penalty amount is deductible.
What If Box 2 Is Greater Than Box 1 and I Can't Save My Form 1099-INT?
If the software won't let you save Form 1099-INT because the amount in Box 2 is greater than the amount in Box 1, you can still enter the deduction separately.
Follow these steps:
- Remove the early withdrawal penalty amount from Box 2 on the Form 1099-INT entry screen.
- Save the Form 1099-INT.
- Enter the penalty separately using the following path:
- Federal
- Deductions (Select My Forms)
- Adjustments to Income
- Penalty on Early Withdrawal of Savings or Certificate of Deposit (CD)
This ensures your interest income is reported correctly and your deduction is still included on your return.