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 tax return.
The IRS allows you to deduct the cost of such penalties when you report them on Form 1099-INT or 1099-OID.
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 Board steadily increased its target federal funds rate throughout 2022. Each time it did that, interest rates on new CDs crept higher.
That means some folks who bought CDs at the beginning of 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 almost upon us, anyone who paid such fees can deduct them on their tax 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 “9 Tax Deductions You Can Claim Without Itemizing.”