Withdrawal Penalty

What Is a Withdrawal Penalty?

A withdrawal penalty refers to any penalty incurred by an individual for the early withdrawal of funds from an account that is either locked in for a stated period, as in a time deposit at a financial institution (e.g., a CD), or where such withdrawals are subject to penalties by law, such as from an individual retirement account (IRA) or 401(k) plan.

Key Takeaways

  • A withdrawal penalty refers to the charge given to an individual if they perform an early withdrawal from a locked or time-specific account.
  • An example of one of these accounts would be a retirement account like an IRA.
  • The amount of a withdrawal penalty depends on many factors, including the type of financial instrument involved.
  • In the case of an IRA, there are specific allowances made for early withdrawal without incurring a penalty tax. 
  • The withdrawal penalty for taking funds from an IRA or other retirement accounts can be expensive.

How a Withdrawal Penalty Works

A withdrawal penalty can vary depending on the type of funds or financial instrument involved, along with other factors. The penalty can be either in the form of forfeiture of interest or an actual dollar amount. When you open an account or become a participant in a retirement plan, you will generally receive in-depth documentation that spells out all of the terms of the arrangement or contract. This typically includes details about what constitutes an early withdrawal, and what penalties, if any, you would incur should you decide to make an early withdrawal from that account.

For example, an early withdrawal from a certificate of deposit (CD) at most financial institutions would result in the customer forfeiting interest for a period ranging from one month to several months. Generally speaking, the longer the term of the initial certificate of deposit, the longer the interest forfeiture period.

An alternative option to taking an early withdrawal is taking a qualified retirement plan loan.

Withdrawal Penalties for IRA Accounts

In the case of IRAs, withdrawals before the age of 59½ are subject to a penalty of 10%. Of course, you'll also have to pay income taxes on the amount withdrawn—from a traditional IRA or 401(k)—since it'll be considered taxable income. The amount you'd pay would be dependent on your total annual income and the subsequent income tax bracket.

The Internal Revenue Service (IRS) does allow for some exceptions to the tax penalties for early withdrawal of IRA funds, under certain circumstances. For example, the penalties may be waived if the funds were withdrawn because the person lost their job and needs funds to make the premium payments on their medical insurance policy.

Also, an early withdrawal might be exempt from tax penalties if the funds are being used for tuition expenses for the account holder, their spouse, or a dependent. Certain restrictions and conditions apply, so it’s important to review the rules set by the IRS prior to taking any actions involving withdrawing funds early from an IRA account.

Special Considerations

It's important to note that a qualified plan, such as a 401(k), can have different rules and penalties for early distributions versus a traditional IRA. For example, the early-withdrawal exception for IRAs doesn't apply to qualified plans for those who are unemployed and wish to use IRA funds for health insurance premiums.

The withdrawal penalty for taking funds from an IRA or other accounts can be steep, so it is wise to consider other strategies for obtaining necessary funds that would not involve the possibility of a significant penalty.

An alternative option might be to take a qualified retirement plan loan. The proceeds of that type of loan are not taxable if the loan abides by certain rules, and repayment follows the required schedule and terms.

Example of a Withdrawal Penalty: Annuity Surrender Charges

Many deferred annuities have a withdrawal penalty in the early years of the contract known as a surrender charge. In such an annuity, an individual places either a lump sum of money or regular installment payments into an account (often with an insurance company).

Some years later, that accumulated money is converted into a regular cash flow stream, in many cases until the annuity holder dies. If the annuitant chooses to take out some of the contributed funds before the annuitization phase, there will be a withdrawal penalty.

The size of the surrender fee will vary among insurers and may be something like 10% if money is touched in the first year or two. Generally, this penalty decreases over time, so it may only be 5% in the fifth year and 1% in the tenth year, as an example.

What Is the 401(k) Early Withdrawal Penalty?

Early withdrawals from a 401(k) account (i.e., before age 59½) incur a 10% penalty. Furthermore, any deferred taxes due on that money will be owed at the time of withdrawal. The penalty is the same for an individual retirement account (IRA).

What Is the Early Withdrawal Penalty for a CD?

Generally, if a CD is not held to maturity there will be an early withdrawal penalty. This is often in the form of interest credited. For example, the penalty on a 24-month CD may be six months' interest. Note that some banks today offer CDs with more flexible terms, with some carrying no penalty for early withdrawals.

What Is a Hardship Withdrawal?

You are allowed to make early withdrawals from qualified retirement accounts under special circumstances. These so-called hardship withdrawals can be made to cover medical emergencies or disability expenses, certain education expenses, and to help purchase a first home. While these will not carry the 10% penalty, you will still owe the deferred taxes on that money.

Article Sources

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  1. Internal Revenue Service. "Retirement Plans FAQ Regarding IRAs." Accessed on Dec. 8, 2020.

  2. Internal Revenue Service. "Hardships, Early Withdrawals and Loans." Accessed on Dec. 8, 2020.

  3. Internal Revenue Service. "Retirement Plans FAQ Regarding IRAs." Accessed on Dec. 8, 2020.

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