What Is the Penalty for Early CD Withdrawal?

A Certificate of Deposit (CD) is a savings account that holds a fixed amount of money for a predetermined period, such as several months or multiple years, in exchange for interest payments from the issuing bank or credit union. CDs offer a fixed interest rate for their term, providing a predictable return on your initial deposit. Accessing these funds before the maturity date typically incurs an early withdrawal penalty, which compensates the financial institution for the broken agreement.

How Early Withdrawal Penalties Are Determined

Financial institutions calculate early withdrawal penalties by forfeiting a specific amount of interest that the CD has earned or would have earned. This typically involves deducting a certain number of days’ or months’ worth of interest, which varies based on the CD’s original term. For example, a CD with a term of six months or less might incur a penalty equivalent to three months of interest, while a five-year CD could have a penalty of 12 months’ interest.

The penalty is generally applied to the interest earned on the amount withdrawn. If the accrued interest is less than the calculated penalty, the difference may be deducted directly from your original principal investment. This means it is possible to lose some of your initial deposit if the penalty exceeds the interest accumulated. The exact calculation method and specific penalty terms are detailed in the CD agreement.

Key Factors Influencing the Penalty

Several variables influence the overall size of an early withdrawal penalty. The original term length of the CD is a significant factor, with longer-term CDs typically carrying higher penalty periods. For example, a short-term CD might have a penalty of 90 days’ interest, while a long-term CD could require forfeiture of 365 days’ interest or more.

The interest rate of the CD also impacts the actual dollar amount of the penalty. A higher interest rate means that the forfeiture of a certain number of months’ or days’ interest will result in a larger financial deduction. Financial institutions have discretion in setting their specific penalty structures, so penalty terms can vary significantly from one bank or credit union to another.

Tax Considerations for Early Withdrawals

Interest earned on a Certificate of Deposit is generally considered taxable income in the year it is credited or made available, even if some is later forfeited due to early withdrawal. Financial institutions are required to report this interest income to the Internal Revenue Service (IRS) and provide you with Form 1099-INT, which details both the total interest earned and any early withdrawal penalty incurred.

The early withdrawal penalty itself may be tax-deductible. This deduction can reduce your taxable income, potentially offsetting a portion of the interest earned. The penalty amount is typically reported in Box 2 of Form 1099-INT and can be deducted on Schedule 1 (Form 1040), line 18, as an adjustment to income. It is important to consult a tax professional for guidance on properly reporting CD interest and deducting penalties.

Situations Where Penalties May Be Waived

In specific circumstances, financial institutions may waive early withdrawal penalties. A common scenario for a waiver is the death of the CD holder. Similarly, if the CD holder is adjudicated as legally incompetent, institutions often have provisions to waive the penalty. These situations are generally recognized exceptions that allow heirs or guardians to access funds without the standard charges.

Beyond these specific events, some financial institutions might consider waiving penalties in cases of documented financial hardship or other unique circumstances. Such waivers are typically granted at the discretion of the bank or credit union and are not legally mandated in most situations. Requesting a waiver usually requires providing appropriate documentation to support the reason for the early withdrawal.