Certificate of Deposit

The Reasons Behind CD Penalties - What to Expect

Financial institutions expect you to keep your money invested for a minimum period.  You can expect CD terms to be 3-6 months, a year, or 5 years. In exchange, the institution is willing to offer you a higher interest rate. Institutions or banks benefit knowing that they have a certainty on how long your money will be invested without frequent transactions.  These institutions or banks have made other commitments with your money to other customers or to buy other investments.

CD Early Withdrawal Penalty: Tax Deduction

CD’s are intended to be held until maturity, at which time the money can be withdrawn along with any interest gains. They are not designed to give the CD owner the freedom to make multiple transactions, deposits or withdrawals each day.  If you are thinking about withdrawing your money from a certificate of deposit or other time-deposit savings account prior to your certificate maturing, or anniversary date, you may incur a penalty for early withdrawal. This penalty is charged by the bank and withheld directly from your proceeds from the certificate. CD withdrawal penalties are tax deductable!

As an example, if a person was charged an early withdrawal penalty of $1000 for breaking a banking certificate of deposit (CD) before maturity, and that person's highest taxable income was in the 35% bracket, then the deduction would reduce the overall tax bill by $350.

What if I haven't earned any interest yet?

If you are looking to cash-out early from your CD before it earned any interest, your bank may “invade the principal”, or take away some of your initial investment. That means you could walk away with less than you invested.

Lost Opportunity Costs

Opportunity cost is the cost related to
what is being given up relative to an alternative. If an investor has a $100,000.00 CD earning 1.5%apy for
one year he stands to earn $1,500.00 interest. If an alternative investment
were available paying 4%apythat rate would generate $4,000.00 interest on his $100,000.00 investment. Because the investor chose the CD his opportunity cost was $2,500.00 ($4,000.00 - $1,500.00 = $2,500.00)

In this example if the 4% became available after the investor bought his CD at 1.5%, he may be better off paying a penalty to break the CD before maturity and reinvest the money at the higher paying rate. Let’s say the CD was 3 months old and the penalty on the CD to break it was 3 months worth of interest. The investor would receive a return of his $100,000.00 principal.  If the investor reinvested the proceeds into the alternative paying 4% for the remaining 9 months of the original CD term, he would be further ahead. $100,000.00 earning 4% for 9 months is $3,000.00.

If the investor stayed in his original CD at 1.5% he would have $101,500.00 at the end of his term. By taking a penalty and reinvesting the proceeds at the higher rate the investor ended up with $103,000.00 in the same time period.  The opportunity cost for the investor to stay in his CD paying 1.5% is $1,500.00.  ($103,000.00 - $101,500.00 = $1,500.00) Now let’s take into account the CD penalty tax deduction and depending on which tax bracket the investor is in they will further reduce the net penalty thru a tax deduction. Contact us to see if you would be further ahead to get out of low paying investments before maturity for higher guaranteed rates.


How to Avoid CD Penalties

  • Ask your financial institution or advisor, they may waive the penalty for you.

  • Speak with a representative in person to find out what other options you may have.

  • You may also qualify for a waiver of termination, such as death, disability, retirement, or other life events.

How much is a CD penalty?

Banks will typically charge you a penalty that amounts to some of the interest you would have earned if you held the CD to maturity. You might see it quoted as “90 days of interest” for early withdrawal. There is no maximum penalty amount.  

Several institutions may have you pay 30 to 90 days of interest on CD’s that have less than a one-year term. For CD’s with a term longer than a year, you can expect to pay at least 90 days worth of interest. As the term lengthens, so does the penalty. Not all institutions are the same, so make sure you find out before you surrender your certificate.

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