What Is an Early Withdrawal?
The term early withdrawal refers to the removal of funds from a fixed-term investment prior to the allowed date. Early withdrawals can be made from investment vehicles, such as annuities, certificates of deposit (CDs), or qualified retirement accounts, 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.
- An early withdrawal occurs when funds that have been set aside in fixed-term investments are taken out prematurely.
- Early withdrawals are features of products like annuities, CDs, permanent life insurance, and qualified retirement accounts.
- Taking an early withdrawal often results in fees, including penalties and taxes owed.
- Current IRS rules state that an early withdrawal occurs at any point before the saver is 59½ years old from qualified retirement accounts like a 401(k).
- There are certain exceptions where investors don't incur penalties and fees for taking early withdrawals from certain retirement accounts.
Understanding Early Withdrawals
Certain investments are designed to allow investors to grow their money. This requires investors to agree to lock in their cash for a certain period of time. In other cases, investors save their money for retirement. Vehicles like CDs provide investors with a guaranteed interest rate after locking in their money between a month or several years before they mature. The money in retirement savings accounts grows and provides investors with tax benefits and income during retirement.
But there may come a time when the investor needs the money before the maturity date. When an investor takes an early withdrawal, they 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.
An account holder can be penalized if they do not withdraw funds by a certain point. Note that these are not early withdrawals. Instead, they are called required minimum distributions (RMDs).
For example, in a traditional, SEP, or SIMPLE IRA, qualified plan participants must begin withdrawing by April 1 following the year they turn 73. This rule was put into effect with the passing of the SECURE Act 2.0 in December 2022. Prior to this, the age was 72 for anyone who turned that age between Jan. 1, 2020, and Dec. 31, 2022.
Each year the retiree must withdraw a specified amount based on the current RMD calculation. This is generally determined by dividing the retirement account's prior year-end fair market value (FMV) by life expectancy.
If an investor fails to take their RMD, the Internal Revenue Service (IRS) imposes a penalty of 25% of the value of the missed withdrawal. The fee can be reduced to 10% if the mistake is rectified by the date that the penalty if imposed.
Types of Early Withdrawals
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 often decreases 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 in the 20th 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.
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. As such, 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 for any investment growth, but not on the principal balances.
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.
For instance, if the holder of a traditional IRA 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. But if the withdrawal may be exempt from the penalty if it meets one of these stipulations :
- The funds are for the purchase or rebuilding of a first home for the account holder or qualified family member (limited to $10,000 per lifetime)
- The account holder becomes disabled before the distribution occurs
- A beneficiary receives the assets after the account holder’s death
- Assets are used for medical expenses that were not reimbursed or medical insurance if the account holder loses their employer’s insurance
- The distribution is part of a Substantial Equal Periodic Payment (SEPP) program
- It is used for higher education expenses
- The assets are distributed as a result of an IRS levy
- It is a return on non-deductible contributions