Ramifications of Early Withdrawal Penalty Deduction

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If you withdrew money from a certificate of deposit or other time-deposit savings account prior to your certificate maturing, regrettably, you may have incurred a penalty for that early withdrawal. This penalty is charged by the bank and it's withheld directly from your proceeds from the certificate of deposit. However, what you may not know, is that this penalty on your early withdrawal of savings can be deducted on your tax return.

Penalty Source Documents

If you receive a Form 1099-INT from the bank, the early withdrawal penalty will be reported in Box 2. The penalty also is also reported in Box 2 of Form 1099-OID.

Where to Report the Penalty on Your Tax Return

The early withdrawal penalty is reported on the front of your tax return on Line 30 of your Form 1040. It's important to note that you will need to file the long Form 1040 to claim this deduction because the line item is not found on the shorter Form 1040A or 1040EZ. 

Possible Tax Impacts

The penalty for early withdrawal of savings is considered an adjustment to your income. As such, this deduction reduces your adjusted gross income. By reducing your adjusted gross income, this also lowers your taxable income and hence, lowers your tax.

Reducing adjusted gross income (AGI) has a ripple effort, impacting other parts of your tax return that are calculated based on your AGI.

The net investment income tax, the premium assistance tax credit, the child tax credit, and the itemized deduction for medical expenses, for example, are all calculated, in part, by referring to your AGI. Therefore, reducing your AGI can reduce your taxes directly (by reducing your income), but it can also increase other deductions, increase other tax credits, or reduce other taxes.

Instructions for Form 1099-INT

   Box 2. Early Withdrawal Penalty
Enter interest or principal forfeited because of an early withdrawal of time deposits, such as an early withdrawal from a certificate of deposit (CD), that is deductible from gross income by the recipient. Do not reduce the amount reported in box 1 by the amount of the forfeiture. For detailed instructions for determining the amount of forfeiture deductible by the depositor, see Rev. Ruls. 75-20, 1975-1 C.B. 29, and 75-21, 1975-1 C.B. 367.
Instructions for Form 1040 Line 30
   Line 30
Penalty on Early Withdrawal of Savings
The Form 1099-INT or Form 1099-OID you received will show the amount of any penalty you were charged.
Internal Revenue Code section 62
   (a) (9) Penalties forfeited because of premature withdrawal of funds from time savings accounts or deposits
The deductions allowed by section 165 for losses incurred in any transaction entered into for profit, though not connected with a trade or business, to the extent that such losses include amounts forfeited to a bank, mutual savings bank, savings and loan association, building and loan association, cooperative bank or homestead association as a penalty for premature withdrawal of funds from a time savings account, certificate of deposit, or similar class of deposit.

More information from the IRS: