Question

Llona invested $100,000 in an 18-month certificate of deposit. She needed to cash in the CD to meet some unexpected expenses. Llona earned $2,000 in interest income from the CD, but she only received $1,800 because the amount was reduced by a $200 penalty for early withdrawal. How will these amounts be treated for tax purposes?

A) Llona will report the $2,000 as gross income and deduct the $200 as an itemized deduction (from AGI).
B) Llona will report the $2,000 as gross income, but the $200 penalty is not deductible.
C) Llona will report the $2,000 as gross income and deduct the $200 for AGI.
D) Llona will not report the $2,000 as income because she incurred a penalty.

Answer 1

Llona must report the full $2,000 as gross income for tax purposes but can deduct the $200 early withdrawal penalty for AGI, thus aligning with IRS guidelines.

Step-by-step explanation:

When Llona invested $100,000 in an 18-month certificate of deposit and later cashed in the CD early, she earned $2,000 in interest income from which a $200 penalty for early withdrawal was deducted, leaving her with $1,800. For tax purposes, Llona will need to report the full $2,000 as gross income on her tax return. However, the $200 penalty she incurred can be deducted for adjusted gross income (AGI), not as an itemized deduction from AGI. Therefore, the correct tax treatment for these amounts would be:

C) Llona will report the $2,000 as gross income and deduct the $200 for AGI.

Penalties for early withdrawal of savings are deductible for AGI, helping reduce the overall taxable income. This treatment aligns with the Internal Revenue Service's guidelines for reporting income and deducting certain types of penalties.