Anytime you earn more than $10 in interest, your bank is required to send you a Form 1099-INT to document the income for tax purposes. But, the same form is also used to note any early withdrawal penalties it charged you during the year. While it won't save you as much as the entire early withdrawal penalty cost, you can deduct the early withdrawal penalty on your tax return.
Any penalties your bank takes out of your interest counts as an income tax deduction for you. These early withdrawal penalties are common on CDs that you withdraw before they mature. Bankrate.com's 2012 survey claims the average penalty is 90 days of interest for CDs with maturities under one year and 180 days for longer CDs. (But, instead of simply reducing the amount of taxable interest the bank reports on your 1099-INT, the bank reports the penalty in a separate box.)
To claim the deduction you must use Form 1040 -- not Form 1040A or Form 1040EZ. But, you can still claim the deduction even if you don't itemize. After you've reported all your interest income, you report the amount of the penalty on line 30, which reduces your adjusted gross income. For example, say you have $1,600 of interest and a $300 penalty. All $1,600 of the interest gets reported as taxable income and then the $300 penalty gets reported as a tax deduction, making the net impact on your AGI only $1,300.
No Size Limit
According to Bankrate.com, when you cash out a certificate of deposit early, 97 percent of banks will dip into your original deposit to pay the penalty. For example, if you owe $150 in penalties but you've only earned $100 in interest, the bank will take out $50 from your principal. Luckily for you, the IRS doesn't limit the amount of your deduction to the interest income, so you always get to deduct the entire penalty.
The early withdrawal penalty is reported separately from your interest income for the year and doesn't impact whether or not you must file Schedule B for your interest income. Schedule B is required if you have more than $1,500 in interest income for the year, regardless of your losses due to penalties. For example, say you have $1,600 of interest income but a $300 early withdrawal penalty. Even though your net income is under $1,500, you still must file Schedule B because your interest is $1,600 for the year.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."