The Early Withdrawal From Savings Penalty Tax Deduction
You Must File an Additional Schedule to Claim This Deduction
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, and 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 greater than the amount or percentage 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 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, and 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 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, clearly identified as an "early withdrawal penalty." It's also reported in box 3 of Form 1099-OID, "Original Issue Discount," also identified here as an "early withdrawal penalty."
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 as well.
You can deduct the penalty even if it's more than what appears in box 1 of Form 1099-INT.
Changes Since 2017—A New Form 1040
The early withdrawal penalty used to be reported on the front of your return, on Line 30 of Form 1040 prior to tax year 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 whole new Form 1040 came into play. It replaced the old 1040, as well as the 1040A and 1040EZ. The IRS and the Treasury Department made the revisions to accommodate the changes made to the tax code by the Tax Cuts and Jobs Act. Then, to further complicate things, the IRS again revised the 1040 for the 2019 tax year.
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. It still has the same effect on your tax situation. You just won't claim it directly on your 1040 return in years 2018 or later. You'll have to take an extra step
How to Claim the Penalty
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.
You must enter your penalty on line 17 of Schedule 1, located in Part II of the schedule and marked "Adjustments to Income," beginning with the 2019 tax year when you file your return in 2020. Total all your adjustments to income on line 22 of the schedule, then transfer the total to line 8a of your 2019 Form 1040.
Taxable interest earned should be reported on Schedule B and is transferred to line 2b of your 2019 Form 1040.
You still don't have the option of filing Form 1040A or 1040EZ because those tax forms became obsolete as of 2018.
Possible Tax Impacts
As an adjustment to your income rather than an itemized deduction, claiming your early withdrawal penalty reduces your adjusted gross income (AGI) before you claim any other tax breaks. Reducing your AGI 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 applies only to penalties on regular savings, not the 10% penalty that can be assessed if you take withdrawals from some retirement savings plans before age 59 1/2.
You can additionally claim an adjustment to income and also claim the standard deduction or itemize other deductions as well. This type of tax break is one of the best the IRS offers.