Tax on CD interest penalty
originally posted: 11/22/2006 reposted: 2/18/2011 This post has not been recently reviewed or revised by the author and may be out of date. If in doubt, please send a new question or ask for an update.
Q: Last year I owned a Certificate of Deposit from a local bank that was cashed in early. I reported the amount of interest received on my tax return but the bank reported a higher amount to the IRS that did not reflect the early withdrawal penalty. As a result of the mis-match on the tax forms, I received a deficiency notice from the IRS to pay tax on the interest that I did not receive. What should I do?
A: The tax on interest earnings is actually based on the entire interest that you would have received if you had held the CD until maturity. The IRS Form 1099-INT that you received from the bank probably listed the early withdrawal penalty separately in box 3 and the total amount of scheduled interest in box 1. The early withdrawal penalty is deductible as an "above the line" deduction on your tax return so the net effect on taxable income is offset. It is possible that there could be other unanticipated side-effects of reporting interest income that is more than you actually received, however this is the accounting method that is always followed.
Summary
More resources:
resources