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POSTED BY Ken Tumin
There are two common reasons for making an early withdrawal on a certificate of deposit (breaking a CD): you need the money or there's a better investment for the money. With rising interest rates, you might find it's worth breaking a CD even if you are charged a penalty. If you move the amount into a higher paying CD, it might not take long for you to come out ahead.
Tax Implications
One thing that's not well known is the tax implications of breaking a CD. It doesn't seem fair to pay taxes on interest even though a part of it was taken away due to the early withdrawal penalty. Well, the IRS has this covered. On page 19 of the IRS Publication 550 - Investment Income and Expenses (link to pdf):
One important note is that you might have to report interest from a CD and the penalty in separate tax years. For example, interest from a CD may have been earned in August 2005. If you break the CD in February 2006, the penalty would likely apply for tax year 2006. So you'll have to wait a year before the penalty helps you on your tax bill.
Should you break a CD?
If you're thinking about breaking a CD so you can move the money into a higher interest account, you'll have to weigh the cost of the penalty versus the interest rate gain from the new account. For example, if you are one year into a 5-year CD with $10K earning 3% interest, and it has a 6-month penalty, should you break it if you can put it into a 4-year CD earning 5%?
Here's the math. I'm going to keep it simple by not taking into account compounding.
So by breaking the CD, you'll come out ahead in 4 years by about $650. So don't be afraid to break CDs. It doesn't really complicate your taxes, and you could make a lot more money.
Tax Implications
One thing that's not well known is the tax implications of breaking a CD. It doesn't seem fair to pay taxes on interest even though a part of it was taken away due to the early withdrawal penalty. Well, the IRS has this covered. On page 19 of the IRS Publication 550 - Investment Income and Expenses (link to pdf):
Penalty on early withdrawal of savings. If you withdraw funds from a time-savings or other deferred interest account before maturity, you may be charged a penalty. The Form 1099-INT or similar statement given to you by the financial institution will show the total amount of interest in box 1 and will show the penalty separately in box 2. You must include in income all the interest shown in box 1. You can deduct the penalty on Form 1040, line 33. Deduct the entire penalty even if it is more than your interest income.
One important note is that you might have to report interest from a CD and the penalty in separate tax years. For example, interest from a CD may have been earned in August 2005. If you break the CD in February 2006, the penalty would likely apply for tax year 2006. So you'll have to wait a year before the penalty helps you on your tax bill.
Should you break a CD?
If you're thinking about breaking a CD so you can move the money into a higher interest account, you'll have to weigh the cost of the penalty versus the interest rate gain from the new account. For example, if you are one year into a 5-year CD with $10K earning 3% interest, and it has a 6-month penalty, should you break it if you can put it into a 4-year CD earning 5%?
Here's the math. I'm going to keep it simple by not taking into account compounding.
Gain if 5-year 3% CD is kept for another 4 years:
$10,000 * 0.03 * 4 = $1200 (4 years of interest)
Gain of breaking the CD and re-investing in 4-year 5% CD:
$10,000 * 0.03 * 6/12 = $150 (6-month penalty)
$10,000 * 0.05 * 4 = $2000 (4 years of interest)
$2000 - $150 = $1850 (approximate total)
So by breaking the CD, you'll come out ahead in 4 years by about $650. So don't be afraid to break CDs. It doesn't really complicate your taxes, and you could make a lot more money.
http://www.mlnbank.com/prem_cds.html
These premium CDs are not redeemable for their term. So you can compare a 1yr CD at 5% with an I-bond for 1 yr at around 5%.
If I take out my $10,000 CD and suffer a penalty, I wont have $10,000 to invest in my new CD, only $9850.
So, compared with having $11,200 at the end with scenario 1, I would have $11,820 at the end of scenario 2.
Your theory that there are good times to break your CD still holds.
About my math,thanks Dan for pointing out this inaccuracy. It's similar to my exclusion of compounding.
My credit score is above 700 from each credit bureau.