Tax Guy: Dear Tax Guy: Can I deduct the early-withdrawal penalty if I switch to a higher rate CD?

Dear Seeking CD Help,

The humble and steady certificate of deposit is looking more hip while stock market returns lurch lower and interest rates climb higher.

I asked around and now you might find CDs a little cooler. Turns out you can deduct early withdrawal interest penalties on your taxes, I learned.

“There’s a few little gimmes in the IRS tax code and this seems to be one of them,” said Jonah Gruda, tax partner in the family wealth services group at Marcum. 

“It has long been that way,” said Ken Tumin, founder and editor of DepositAccounts.com, where he tracks the rates on CDs and savings accounts.

Considering the penalty’s tax treatment, “the more mild early withdrawal penalty makes the early withdrawal option more favorable and more useful in this rate environment,” he said.

There are lots of people like you now, trying to make smart moves to maximize a safe return in uncertain times while the Federal Reserve signals a willingness to keep interest higher for longer.

Fidelity Investments recently said customers’ interest in its array of brokered CDs has climbed roughly tenfold from the same point last year. Anecdotally, Tumin said he’s also considering whether to pull money from a five-year CD at 2.3% to plunk it in a CD above 4%.

A CD is a savings vehicle that holds a set sum and accrues interest for a set period, typically ranging from three months to five years. Upon maturity, depositors get their money back, plus interest.

At the start of December, a one-year CD averaged 0.9% and a five-year CD averaged 0.98% but high-yield CDs offer rates above 4%, according to the personal finance site Nerdwallet.com. 

Any sort of guaranteed return on investment is appealing when the Dow Jones Industrial Average
DJIA,
-1.05%
is down 8% year to date while the S&P 500
SPX,
-1.45%
declined more than 18% and the Nasdaq Composite
COMP,
-5.88%
is off by more than 31%.

One catch is the CD’s lock-up period. Pull the money before the maturity date and an early withdrawal penalty of varying size and formula will follow. Common penalties, depending on CD duration, are six-, nine- and 12 months of interest, Tumin said.

Accrued interest is taxable income and the IRS will see that reported in Form 1099-INT. But the form also includes a field for early withdrawal amounts.

Suppose you deposited $2,000 in a two-year CD offering 3.5%. That would garner an extra $71 in interest in first of those two years and almost $145 at maturity. But then you see another CD at 4% that’s yielding $81 interest in the first year and $166 extra at maturity.

Withdrawing after the first year would typically result in a six-month interest penalty, Tumin said. In this hypothetical, that would be around $35. Fast forward to tax time. The CD issuer would send you a 1099-INT, noting the $71 in interest and the $35 early withdrawal penalty.

But the early withdrawal penalty is deductible — and that’s even if you take the standard deduction, Tumin said. So the taxable income from the transaction is $36 (that’s $71 minus $35 in our hypothetical) as opposed to $71, he noted.   

 “It mitigated the tax bite of the foregone interest,” Gruda said. All early withdrawals don’t get the same treatment. For example, the early withdrawal penalty from an IRA is not deductible, he said.

For CDs, the softened tax bite has real-life implications, Gruda said. The spread between the CD at the older, lower interest rate and the CD at the newer, higher interest rate doesn’t have to be so far apart to justify taking the penalty and jumping ship, he said.

Even if CD returns of 4% and 5% can’t beat the pace of inflation now, it’s better than a loss. So CDs are having a moment right now. That’s opposed to compact discs, which are not having a moment now. That’s sad news for the bulging binder of 1990s and early-2000s alternative rock, jam bands and hip hop gathering dust in my attic.

But if you need a music playlist suggestions from my compendium while you rate shop, let me know. In that case, consider me your CD tracks guy.