Understanding the implications of early withdrawal from a certificate of deposit (CD)
Quick insights
- Most people use certificates of deposit (CDs) to save long term.
- Your initial deposit traditionally receives interest at a fixed rate until the predetermined time period.
- Withdrawing money before the CD matures—referred to as an early withdrawal—usually triggers a penalty fee.
When you purchase a CD, you agree to leave your money in an account for a set term, a period of months or years. Withdrawing before the end of that term may result in a penalty, which we’ll explain in this article.
Introduction to certificates of deposit (CDs)
A certificate of deposit (CD) is a financial product offered by banks and credit unions. A CD provides an interest return in exchange for depositing a sum of money and leaving it alone for a specified period. This could range from months to years. At the end of the term, you receive your initial deposit plus the accrued interest.
Types of CDs
- Traditional CD: Offers a fixed interest rate and fixed maturity date.
- Jumbo CD: Requires a large minimum deposit, such as $100,000, and offers a higher interest rate.
- Bump-up CD: Allows you to increase your interest rate one time during the term if rates rise.
- Liquid CD: Permits limited withdrawals without penalties but generally offers lower interest rates.
- Zero-coupon CD: Sold at a discount and pays no interest until maturity, when you receive the face value.
CDs in personal finance
CDs are ideal to save for specific future expenses, such as a down payment on a house. This is because a CD can protect your principal while providing predictable interest earnings.
Here are several additional benefits of CDs:
- CDs are generally low-risk accounts and deposits are usually insured by the FDIC up to the maximum amount allowed by law.
- A fixed interest rate means you know exactly how much a CD will earn over the course of the term, helping you plan your financial future with some precision.
- Various types of CDs cater to different financial goals and risk tolerances.
The concept of early withdrawal from a CD
When you withdraw money from a CD before the maturity date, this is considered an early withdrawal. Reasons for withdrawing early can vary, but the primary benefit is getting immediate access to your money. This can be crucial in emergencies or when you find an alternate opportunity to deposit your money.
The impact of early withdrawal
The major drawback of withdrawing early from a CD is a penalty imposed by the bank or credit union. The exact CD early withdrawal penalty varies based on the CD’s terms. This typically involves forfeiting some or all of the interest earned, and sometimes even a portion of the principal.
Understanding CD early withdrawal penalties
A CD early withdrawal penalty is a fee imposed by the bank or credit union if you withdraw your CD before it matures. Penalty terms can vary by institution, but in general, the early withdrawal penalty may diminish or totally negate the financial benefits of the CD.
How the penalty is typically calculated
The early withdrawal penalty is usually calculated based on a portion of the interest that the CD would have earned. The exact penalty varies by institution and the terms of the CD, but common methods include:
- Portion of interest earned: The penalty might be equivalent to several months’ worth of interest.
- Percentage of the interest: Some institutions may charge a penalty that is a percentage of the total interest expected to be earned over the CD term. If the interest accrued is less than the penalty, the difference may be deducted from the principal.
- Combination method: In some cases, the penalty may be a combination of several figures, such as several months’ worth of interest and a percentage calculation.
Example: Early withdrawal penalty for a five-year CD
If you buy a five-year CD and decide to withdraw your money early, you will likely face a penalty. As an example, let’s assume you have this five-year CD:
- Initial deposit: $10,000
- Annual interest rate: 2%
- Early withdrawal penalty: 12 months’ interest
If you withdraw after two years:
- Interest earned = $400 ($10,000 x 2% = $200 per year)
- Penalty = $200 (12 months’ interest)
- Net earnings after penalty = $200 ($400 interest earned – $200 penalty)
Reporting a CD early withdrawal penalty
Withdrawing from a CD at any time can have tax implications. Any interest earned on the CD is considered taxable income and must be reported on your tax return. If you withdraw money early from a CD, you are still responsible for paying taxes on the interest earned up to that point.
Early withdrawal penalties are also significant for taxes. Any penalties you incur for early withdrawal can be deducted from your taxable income, reducing your overall tax liability. However, these deductions are subject to certain limitations. Consult a tax professional or refer to IRS guidelines for detailed information on how to properly report income and losses from CDs.
In conclusion: Making decisions about CDs and early withdrawal
The main benefit of using a CD is a stable, predictable return. Before you buy a CD, try to ensure you can leave the money untouched for the CD’s term. Then, you can shop for the best rates while keeping other financial products in mind that might also suit your situation and savings goals. CD renewal may also be available.
Access to money in an emergency or taking advantage of better opportunities to build your money can justify a CD early withdrawal penalty. This is meant to discourage premature withdrawals but doesn’t prohibit them. Only you can determine if an early withdrawal is necessary. What can help you decide is understanding how the penalty fee is calculated, including how much your withdrawal will actually net.