By understanding how early withdrawals work, you can try to avoid charges and penalties on accounts that have them.
Definition and Example of Early Withdrawal
An early withdrawal is when you prematurely remove money from an account like a retirement account, annuity, or other investment vehicle with a defined withdrawal date. These funds were set aside for a specific period of time, and you can face consequences if you remove the money early. Most retirement investments come with an early withdrawal penalty, which is meant to deter investors from taking their money from a source of retirement income. For instance, anyone who makes an early withdrawal from an individual retirement account (IRA) before the age of 59½ will pay a 10% early withdrawal tax.
How Early Withdrawal Works
If you put your money in a CD, retirement account, or annuity, you’ll be required to leave it there for a certain period of time. And if you withdraw some or all of the funds early, you’ll have to pay an early withdrawal penalty. For example, let’s say you have $100,000 saved in an employer-sponsored 401(k). You haven’t yet reached retirement age, but you want to withdraw $10,000 to use as a down payment to buy a home. Because you’re under 59½, you’ll have to pay a 10% early withdrawal fee. That means you’ll pay a $1,000 fee, and you’ll have to pay taxes on the money you withdrew when you file your yearly taxes.
Types of Early Withdrawals
The consequences of making an early withdrawal will vary depending on the type of account you withdraw money from and the terms of that account. Here are some common financial products that often have a specific time for when you can make withdrawals.
Certificate of Deposit (CD)
A CD is a savings account where your money is held for a specific term. CD terms offer interest for a specific period of time, such as six months or five years. Once the term is up, you’ll cash in your CD and receive your original investment back, along with any interest earned. However, there are penalties for withdrawing the money before the term is up. The exact penalty will depend on the terms of your account, and there is no maximum penalty. But if you withdraw the funds within six days of opening the account, you’ll have to pay at least seven days of simple interest.
Retirement Account
For retirement accounts like 401(k)s, Roth IRAs, and traditional IRAs, the IRS sets certain penalties for withdrawing funds early from your retirement account. Generally, any money you receive before the age of 59½ is considered an early distribution. Unless you qualify as an exception, you’ll have to pay a 10% early withdrawal penalty.
Annuity
Annuities are taxed differently depending on the type of annuity they are, namely whether they are qualified or non-qualified. Qualified annuities are funded with pre-tax dollars, while non-qualified annuities are funded with after-tax dollars. If you withdraw money from your annuity before the age of 59½, you’ll pay a 10% early withdrawal fee. On a qualified annuity, your entire distribution may be subject to this penalty. On a non-qualified annuity, your earnings and interest are subject to this penalty.
Whole Life Insurance
One of the advantages of taking out a whole life insurance policy is that you can make cash withdrawals. And the longer you’ve owned the policy, the larger your cash value will be and the more options you’ll have for making a withdrawal. Before canceling or withdrawing cash from a life insurance policy, speak with your insurance agent about your options.
