Deduct Penalty on Savings Withdrawal

(This is part of a series looking at various common 1040 questions. To go back to the summary page, click here)

It’s been a while since I’ve talked about tax helps, so I thought it was about time to get back on that cart. I mean, how else am I going to have enough content to publish my surefire NY Times bestseller, “Your Taxes And You: How to Learn to Love April 15th”?

Okay, the title’s still pending.

Back to the topic at hand, which is the penalty on savings withdrawals.

Have you ever put your money in some sort of timed deposit, like a timed savings account or certificate of deposit, only to realize that you really needed that money before the time expired (or maybe just really wanted that new Non-Apple phone. I’m judging you)? Most financial institutions will gladly give you your money back, but only after hitting you with some kind of penalty.

There is some good news. Code Section 165 potentially allows you to deduct that penalty.

In the real world, what that means is at the end of the year you’ll get a nice 1099-INT or 1099-OID that shows how much of a penalty you were charged for your early savings withdrawal. Simply take that number and stick it on your 1040 (Line 30 in 2013).

Since this is one of those “Above the Line” deductions, it means you’ll actually get the whole deduction, instead of having a potentially limited Schedule A deduction. Which is good news. You might have been stuck with some crappy bank penalty, but at least you get a bit back through your tax return.

Plus you got that Blackberry Passport that's so in demand!

Plus you got that Blackberry Passport (that you probably didn’t even know what a real phone before you saw it here)!

Honestly, when I read about this deduction, it seemed inconsistent with the IRS’s typical treatment of personal losses. Typically the IRS will tax all your personal income but give you the middle finger for deducting any personal expenses. So why is this savings withdrawal penalty allowed?

The logic, as far as it goes, is that opening up a timing savings account is entering into a for profit transaction, so any expenses are considered part of that transaction. Think of it as a very small business, where you are allowed to deduct your business expenses.

The financial institution has two methods to calculate the savings withdrawal penalty, which should be reported to you somehow (likely on the 1099-INT or 1099-OID or on the contract you sign). The two methods are (1) the gross income and loss method (the gross method); or (2) the modified income and loss method (modified method).

I’m not going to get into how to actually calculate the two methods right now. If anyone is curious, let me know and I’ll post some examples. I originally started writing them down, but it was so painfully dry that I started putting my self to sleep. I’m sure it’s the kind of thing that bankers find fascinating, though.

So there you go. That “one weird trick” to get a tiny amount of money back if you got hosed by withdrawing from timed savings account early.

Photo by Maurizio Pesce