You'll most likely have to pay a penalty if you withdraw money from a certificate of deposit (CD) or other time-deposit savings account before it matures. This fee is charged by the bank or financial institution, and it's withheld from your certificate of deposit or other account. The penalty on the early withdrawal of savings can be deducted on your tax return, however.
It's an "above the line" adjustment to income, one of the better deductions that's available.
Why a Penalty?
Your CD deposit earns interest that's usually a greater percentage than that which is earned by a run-of-the-mill savings account. You must commit to leaving your money with the financial institution for a prescribed period of time in exchange for this favorable interest rate. The bank will take back at least some of this "extra" interest if you pull your money out early.
The penalty is usually about six months' worth of interest, but it can be as much as a year's interest.
The penalty is a set amount, provided for in your contract with the institution. It's typically the same whether you take out $20 or $2,000. The IRS says the penalty is deductible because it affects the amount of interest you'll earn.
Documents You'll Need
You should receive a Form 1099-INT from your bank or financial institution after the close of the tax year if you've been subject to an early withdrawal penalty. The penalty will be reported in box 2 on the tax year 2021 form, clearly identified as an "early withdrawal penalty." It's also reported in box 3 of Form 1099-OID, "Original Issue Discount." It's identified here as an "early withdrawal penalty" as well.
The total amount of interest your account earned will appear in box 1 of Form 1099-INT, and you must include this as income on your return.
You can deduct the penalty even if it's more than what appears as interest earned in box 1 of Form 1099-INT.
Changes Since 2017—A Redesigned Form 1040
The early withdrawal penalty used to be reported on line 30 of the Form 1040 tax return prior to 2018. You had to file the long Form 1040 to claim this deduction back then because this line item wasn't found on the shorter Forms 1040A or 1040EZ.
Beginning with tax year 2018—the return you filed in 2019—a redesigned Form 1040 came into play. It replaced the old 1040, as well as the 1040A and 1040EZ. The IRS made the revisions to accommodate changes made by the Tax Cuts and Jobs Act.
Then, to further complicate things, the IRS again revised the 1040 for the 2019 tax year. It made some further minor tweaks for the 2020 tax year, the return you'd file in 2021.
The end result is that this deduction survived all these changes, and it's still claimed "above the line" as an adjustment to income—not an itemized deduction—but in slightly different places depending on the year in which you're claiming it. It still has the same effect on your tax situation, but you won't claim it directly on your tax return in years 2018 or later. You'll have to take an extra step.
How to Claim the Deduction
The revised returns significantly shortened the old Form 1040 that was in place prior to 2018. Information that used to be entered directly on Form 1040 was moved to various numbered schedules. The total from the schedules is then transferred to your Form 1040.
Enter your early withdrawal penalty on line 17 of the 2020 Schedule 1, located in Part II of the schedule, "Adjustments to Income." Total all your adjustments to income from Part II on line 22 of the schedule, then transfer this sum to line 10a of your 2020 Form 1040.
Taxable interest earned should be reported in Part I of Schedule B, "Interest and Ordinary Dividends." It's transferred to line 2b of your 2020 Form 1040.
You don't have the option of filing Form 1040A or 1040EZ any longer because those tax forms became obsolete as of 2018.
Tax Impacts of Adjustments to Income
As an adjustment to your income rather than an itemized deduction, claiming your early withdrawal penalty reduces your adjusted gross income (AGI). This reduces your taxable income and, by extension, lowers your tax.
Reducing your AGI has a ripple effort as well, impacting other parts of your return that are calculated based on your AGI. The net investment income tax, the child tax credit, and the itemized deduction for medical expenses are all calculated based on your AGI. Reducing your AGI can reduce can also increase other deductions, increase other credits, and reduce other taxes.
This tax break only applies to penalties on regular savings, not the 10% penalty that can be assessed if you take early withdrawals from some retirement savings plans before age 59 1/2.
You can claim an adjustment to income and additionally claim the standard deduction or itemize other deductions as well. This type of tax break is one of the best the IRS offers.