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If you paid a penalty for the early withdrawal of funds from a time savings account or certificate of deposit, you can deduct it, even if it exceeds the interest income you earned on the account during the year.
You must first report the gross amount of interest paid or credited to your account during the year without the penalty, on Line 1 of Schedule B. Then, you deduct the penalty amount on Line 30 of Form 1040 (you can't claim this deduction on Form 1040A or 1040-EZ).
You don't have to compute the amount of the deduction, because it will be shown in Box 2 of your Form 1099-INT.