Early Withdrawal

What Is an Early Withdrawal?

Early withdrawal refers to the removal of funds from a fixed-term investment, such as from an annuity, certificate of deposit (CD), or qualified retirement account, before the maturity date. Doing so can result in fees and penalties being levied on the tax-deferred money coming from certain retirement savings accounts before age 59½.

Understanding Early Withdrawals

When an investor or saver takes an early withdrawal, they will typically incur some sort of pre-specified fee. This fee helps to deter frequent withdrawals before the end of the early withdrawal period. As such, an investor usually only opts for early withdrawals if there are pressing financial concerns or if there is a markedly better use for the funds.

Certain long-term savings vehicles such as CDs have a fixed-term, such as six months, one year, or up to five years. If the money inside the CD is touched before the term is over, savers are subject to a penalty that will often decrease in severity as the maturity date approaches. For example, you will be subject to a far larger fee if you withdraw early CD funds in the second month than the twentieth month. Certain life insurance policies and deferred annuities also have lock-up periods during the accumulation phase, which are also subject to penalties if withdrawn early, known as a surrender charge.

Early Withdrawal and Required Minimum Distributions

In contrast, with early withdrawal penalties, on the other end, an account holder can be penalized if they do not withdraw funds by a certain point. For example, in a traditional, SEP, or SIMPLE IRA, qualified plan participants must begin withdrawing by April 1 following the year they reach age 72. Each year the retiree must withdraw a specified amount based on the current required minimum distribution (RMD) calculation. This is generally determined by dividing the retirement account's prior year-end fair market value by life expectancy.

Early Withdrawal and Tax-Deferred Investment Accounts

Early withdrawal applies to tax-deferred investment accounts. Two major examples of this are the traditional IRA and 401(k). In a traditional individual retirement account (IRA), individuals direct pre-tax income toward investments that can grow tax-deferred; no capital gains or dividend income is taxed until it is withdrawn. While employers can sponsor IRAs, individuals can also set these up individually. Roth IRAs are also subject to early withdrawal penalties of any investment growth, but not on principal paid in.

In an employer-sponsored 401(k), eligible employees may make salary-deferral contributions on a post-tax and/or pre-tax basis. Employers have the chance to make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature. As with an IRA, earnings in a 401(k) accrue tax-deferred.

In a traditional individual retirement account (IRA), for example, if an account holder takes a withdrawal before the age of 59½, the amount is subject to an early-withdrawal penalty of 10%, and they must pay any deferred taxes due at that time. If the withdrawal meets one of the following stipulations, however, it could be exempt from the penalty: