DEFINITION of Early Withdrawal
Early withdrawal refers to the removal of funds from a fixed-term investment such as a certificate of deposit (CD) before the maturity date, as well as to the removal of funds from a tax-deferred investment account or retirement savings account before the prescribed time.
BREAKING DOWN Early Withdrawal
In both scenarios, when an investor takes an early withdrawal is made, she or he usually incurs a 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 she or he has a markedly better use for the funds.
In an IRA, for example, if an account holder takes a withdrawal before the age of 59.5, the amount is subject to an early-withdrawal penalty of 10%. If the withdrawal meets one of the following stipulations, however, it could be exempt from the penalty:
- 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 his or her employer’s insurance.
- The distribution is part of a SEPP (Substantial Equal Periodic Payment) 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.
Early Withdrawal and Required Minimum Distributions
In contrast, with early withdrawal penalties, on the other end, an account holder can be penalized if s/he does 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 70 1/2. 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 pretax 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.
In an employer-sponsored 401(k), eligible employees may make salary-deferral contributions to 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.