When you invest in a certificate of deposit (CD) make sure that you won’t need this money before the end of its term. Although you can legally withdraw this investment early, you will almost always pay a penalty for doing so. Sometimes a fairly steep one.This is called an “early withdrawal penalty.” Here’s what you need to know.

If you need help picking investments, a financial advisor could guide you in putting a portfolio together based on your goals and needs.

What Is a CD?

A certificate of deposit, or “CD,” is a depository asset that you can invest in. Specifically, this is what’s known as a “time deposit,” because it’s a savings account locked in for a preset period (such as three months or five years). 

When you open a certificate of deposit, you put an amount of money on deposit with the bank. You agree to keep this money in place for a specific amount of time, and in exchange the bank pays you a fixed interest rate. The bank gets the security of knowing the capital will remain in place (meaning that you won’t withdraw it), and in exchange it pays you a larger interest rate than with more liquid accounts like checking or savings. 

A certificate of deposit will typically have a minimum deposit amount. For example, a regular CD might require a minimum of $500 or $1,000 to buy-in, meaning that you must invest at least that much to open the account.

At the end of its term, a CD “matures” and you receive your money back, plus the account’s accumulated interest. Certificate of deposit terms can range widely, from one month to 10 years or more. In general, the account’s interest rate will be determined by the account’s term and investment.

For example, you might invest in the following product: A five-year CD, minimum investment $10,000, fixed interest rate of 4%. This would mean you must put at least $10,000 on deposit, and you must keep your money in that account for five years. During that time the bank will pay a compounding 4% rate into the account, and in five years you will receive the $10,000 back plus the total interest earned. At that point, you will often have the option to renew the CD if you choose.

You should note that as a depository banking product, CDs are FDIC insured up to $250,000 per depositor. There are many different types of CDs you can invest in, so you should compare the rates, terms, and deposit requirements and limits to see which suits your needs and goals best.

What Is an Early Withdrawal Penalty?

Legally, you can withdraw your money from a certificate of deposit before the end of its term. However, doing so will significantly disrupt the bank’s finances. The entire point of a CD is that it gives the bank secure capital that it can invest elsewhere. This is why the bank pays a higher interest rate for CDs than more liquid accounts.

As a result, if you take your money out of a CD before the end of its term, you will pay what’s known as an “early withdrawal penalty.” This is a fine that the bank takes out of your account before it returns the rest to you. While there are standard practices, it’s important to understand that there is no legal upper limit to this penalty. A bank can charge you whatever they want in fines. 

However, in general, early withdrawal penalties are calculated based on a period of interest. For example, an early withdrawal penalty might be set at “12 months’ interest,” meaning that the bank will charge you the equivalent of 12 months’ worth of interest payments on this account for taking out the money early. If the penalty exceeds your accumulated interest payments, the bank will take the remainder from your principal.

The early withdrawal penalty may also be set based on when you take out your money. That is, a bank may charge higher penalties for taking your money out earlier, and lower penalties if the CD was nearer to maturity.

There are a few key factors to look for when it comes to calculating any given CD’s early withdrawal penalties:

• Simple vs. compounding interest. Is the penalty simple interest, or is it calculated as compounded interest?
• Calculation period. Is the penalty calculated as daily, weekly, monthly or annual interest?
• Duration penalties. Is the penalty higher or lower depending on how early you withdraw your money?
• Principal or withdrawal. Is the penalty assessed on your entire deposit, or just the amount you withdraw early?

For example, let’s say you have a CD with a 4% interest rate. Your early withdrawal penalty is 6 months’ simple interest on the entire principal regardless of when or how much you withdraw. You invest $10,000 in this product and make an early withdrawal. Your penalty would be calculated as:

• (Interest / 12 Months) * Penalty Months * Account Balance = Penalty
• (0.04 / 12) * 6 * $10,000 = $200

Early withdrawal penalties are typically higher for longer-term CDs. This is typically the only cost involved with a CD. There are usually no costs or fees associated with this product, because this is a loan that you extend to the bank.

Early Withdrawal Penalties and Taxes

You can deduct early withdrawal penalties on your taxes.

As with all tax deductions and offsets, early withdrawal deductions apply to the related income. Here, if you have interest income in a given year you can deduct early withdrawal penalties from that taxable interest income.

So, for example, say that you make $1,000 from interest payments in a given year, but also pay a $200 early withdrawal penalty. You can deduct your that penalty, for a total of $800 in taxable interest income. 

Those losses get reported to you on form 1099-INT. 

Bottom Line

If you withdraw money from a certificate of deposit before the asset’s maturity, your bank will charge you an early withdrawal penalty. The exact amount will depend on your bank and the terms of your CD.

Investing Tips

• Investing in a certificate of deposit can provide you with several benefits. But, depending on your financial circumstances, there are also some drawbacks to consider. Here’s a comparison both.
• If you need investment advice, finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/FG Trade, ©iStock.com/Delmaine Donson, ©iStock.com/Delmaine Donson