MLR

Early withdrawal penalties are deductible

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Penalized for withdrawing funds early? All is not lost.

You are entitled to a deduction for a penalty imposed on an early withdrawal of funds from a timed savings account or a certificate of deposit. And you are entitled to this deduction even if you do not itemize deductions on your 1040 return.

However, you must file Form 1040 to claim this deduction. You cannot claim it on either Form 1040A or Form 1040 EZ.

The Internal Revenue Code has a section that benefits taxpayers who are penalized because they withdrew funds from a certificate of deposit or a timed savings account. When an account owner makes a withdrawal of these types of funds early, the bank or savings institution imposes a penalty.

The amount of this penalty is required to be reported to the taxpayer on Form 1099-INT at the end of the tax year. Line 2 of this form contains the amount of the early withdrawal penalty. The amount of interest income earned during the year on the investment is reported on line 1 of the same form.

In certain instances, the amount of the penalty can exceed the amount of interest income earned on the account.

This type of deduction is referred to as an above-the-line deduction because the deduction is used in completing the taxpayer’s adjusted gross income (AGI). AGI is all of a taxpayer’s sources of income added together, reduced by a group of deductions known as below-the-line deductions.

The deduction of an early withdrawal penalty is an example of one type of above-the-line deduction.