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.