Thursday, August 5, 2010

Pay The Early Withdrawal Penalty?

When you hear the term "Penalty" as in Early Withdrawal Penalty, do you automatically recoil thinking that if you have to pay a penalty that you have done something wrong, something bad? I am here to tell you that one alternative to keeping your cash in a low-yielding money market account or short-term CD is to get a long-term, 5-year CD now. Then "pay the penalty" if you need to withdraw the money, or find a better interest rate later.

I recently opened a 5-year Ally Bank High Yield CD that yields 2.94% APY. Some people may think that it is not a good idea to lock in such a mediocre interest rate for 5 years since only a couple years ago, these interest rates were in the range of 4-5% or higher. However, the rate currently being offered by Ally is much better than any short-term CD or money market available.

The second part of the equation is that Ally Bank charges an early withdrawal penalty of 60-days simple interest if you close your account prematurely. I did some research and found that this is one of the lowest early withdrawal penalties available.

If CD or money market rates go back up to the 4-5% range, I intend to close my CD account, pay the penalty, and establish a new account at the higher rate. I already did some back-of-the-envelope calculations that show I would be much better off doing that even after having to pay an early withdrawal penalty.

Let's take a quick example of a $10,000 CD and for simplicity, round off the interest rate to 3% instead of the 2.94% offered. Assume that you deposit the $10,000 in a 5-year CD, but have to withdraw your money after a year to handle an emergency. At 3% simple interest, you will earn $300 before the penalty. Sixty days of interest equals about $50. So your actual return for the year would be $250, or 2.5%. Even with the penalty, the 5-year CD beats out the typical rate on a 1-year CD (which currently yields about 1.5%) by a wide margin. Another point is that the $50 penalty is tax-deductible as an above the line deduction. (This is line item #30 "Penalty on early withdrawal of savings" on form 1040).

The main risk of a long-term CDs is the chance that interest rates will rise and you’re committed to the lower rate until the CD matures. But with a small early withdrawal penalty, if rates rise significantly, you can still consider withdrawing the money, paying the penalty, and putting the money back into another account with a higher interest rate.

Disclaimer: The example provided here is for illustrative purposes only. I am not providing tax or investment advice. I encourages readers to consult with a tax adviser if they have specific questions about how to deduct early withdrawal penalties on their taxes.

DC

4 comments:

lency said...
This comment has been removed by a blog administrator.
Barb Friedberg said...

This may be the best tip I have heard this year!! I NEVER CONSIDERED THE CONCEPT THAT THE PENALTY MAY BE WORTH PAYING, if the yield is high enough. I am including this in my round up and checking out the numbers for my own portfolio!!

Michael said...

Thanks for writing about the early withdrawal penalty strategy. I have one question related to the tax-deductible nature of the penalty. The way I read the IRS publication, the tax deduction is not about giving you a tax deduction but rather it’s an accounting tool.

Using your example, here is how I think it works. Correct me if I’m wrong.

Using IRS Form 1040, you include in line 8a the $300 you have earned on the CD to the point of your early withdrawal. Then on line 30 you include the $50 penalty. So really the IRS is taxing you on $250, the amount you actually received. If this is true, then this is more about accounting for income you didn’t receive than some sort of tax-deduction. In other words, without line 30, the IRS is taxing you on income you did not actually receive. All line 30 does is ensure you remove that $50 from your income because you never received it in the first place.

pfstock said...

Michael: What you said is essentially correct for this example. My main point about the deduction is that you do not need to itemize (i.e., file a Schedule A form) in order to claim it.

Also, another fine point is that in general the penalty is not limited to the interest you have earned up to the point of your early withdrawal. If you close your CD very soon after opening it, the penalty could be greater than the interest earned. And this would result in a real loss of principal.