If you have purchased a CD — otherwise known as a certificate of deposit — from your bank, you probably know that withdrawing money from it before the term expires usually requires payment of a penalty.
However, you might not realize that this fee you pay for an early withdrawal — which typically amounts to a few months of interest — can be deducted on your federal tax return.
The IRS allows you to deduct the cost of such penalties that are reported on Form 1099-INT or 1099-OID, an annual tax form that you would receive from the bank or other financial institution to which you paid the early-withdrawal penalty.
The value of this tax perk might be relevant to more people this tax season than is normally the case. The U.S. Federal Reserve steadily increased its target federal funds rate seven times in 2022 and once so far this year. Each time the Fed does that, interest rates on new CDs creep higher.
That means some folks who bought CDs in 2022 — or even in previous years, when interest rates were scraping the bottom of the barrel — possibly decided to cash out early on those CDs and pay the penalty in order to get newer CDs paying much higher rates.
Others may have cashed in CDs early to help cover the rising cost of inflation.
Whatever the reason, with tax season upon us, anyone who paid such fees can deduct them on their federal return.
Now, it’s important to remember that a deduction helps you get some, but not all, of your money back.
Unlike a tax credit — which decreases the tax you owe dollar for dollar — a deduction only reduces your taxable income. Essentially, that means the value of a deduction depends on your tax rate.
As we have previously explained:
“Say your tax rate is 22%. A $100 deduction could lower your taxable income by $100, and that in turn could lower your tax bill by $22 (22% of the $100 deduction).”
Still, a deduction can ease some of the pain of paying an early withdrawal penalty on a CD.
Looking for more ways to trim your upcoming tax bill? Check out “8 Tax Deductions You Can Claim Without Itemizing.”