Early Withdrawal Penalty

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Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on July 11, 2023

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What Is an Early Withdrawal Penalty?

An early withdrawal penalty is a financial penalty imposed on individuals who withdraw funds from certain types of accounts, such as retirement accounts or certificates of deposit (CDs), before a specified age or time period.

The penalty is designed to discourage early withdrawals and encourage individuals to keep their funds invested for the long term.

Early withdrawal penalties are most commonly associated with tax-advantaged retirement accounts, such as traditional IRAs, Roth IRAs, and 401(k) plans. Still, they can also apply to other types of time-based savings accounts.

It is important to note that certain exceptions to early withdrawal penalties, such as specific hardship situations or qualified first-time home purchases, may allow individuals to access their funds without incurring a penalty.

Types of Accounts With Early Withdrawal Penalties

Retirement Accounts

  • Roth IRA: Similar to Traditional IRAs, Roth IRAs are retirement accounts with different tax structures. Early withdrawals are subject to penalties unless specific conditions are met.

  • 401(k): Employer-sponsored retirement plans that allow employees to contribute pre-tax income. Early withdrawals typically result in penalties.

  • 403(b): Retirement plans for employees of certain tax-exempt organizations. Similar to 401(k) plans, early withdrawals are penalized.

  • 457 plans: Retirement plans for state and local government employees and some non-governmental organizations. Early withdrawal penalties apply in most cases.

Time-Based Savings Accounts

  • Certificates of Deposit: Financial products offered by banks and credit unions which require the account holder to leave their funds untouched for a specified period. Early withdrawals attract penalties.

Early Withdrawal Penalty Scenarios

Retirement Accounts

  • Withdrawal Before Age 59½: Withdrawing funds from retirement accounts such as IRAs and 401(k)s before age 59½ typically results in penalties.

  • Exceptions for Specific Life Events: Some life events, such as purchasing a first home or paying for higher education, may qualify for penalty-free withdrawals.

Certificates of Deposit (CDs)

  • Withdrawal Before the Maturity Date: Withdrawing funds from a CD before its maturity date incurs penalties.

  • Penalties Based on the Term of the CD: The penalty amount often depends on the term length of the CD.

Early-Withdrawal-Penalty-Scenarios

Exceptions to Early Withdrawal Penalties

Retirement Accounts

  • First-Time Home Purchase: Some retirement accounts permit penalty-free withdrawals for first-time homebuyers up to specified limits.

  • Qualified Higher Education Expenses: Penalty-free withdrawals may be allowed for qualified higher education expenses.

  • Medical Expenses: Certain unreimbursed medical expenses may qualify for penalty-free withdrawals.

  • Disability: In case of total and permanent disability, early withdrawal penalties may be waived.

  • Inherited Retirement Accounts: Inheriting a retirement account may allow the beneficiary to withdraw funds without incurring penalties.

Time-Based Savings Accounts

  • Promotional Terms and Conditions: Promotions or specific account terms may waive early withdrawal penalties under certain conditions.

    Exceptions-to-Early-Withdrawal-Penalties


Calculating Early Withdrawal Penalties

Retirement Accounts

Penalties for early withdrawals from retirement accounts typically amount to 10% of the withdrawn funds and regular income taxes.

For example, an individual withdrawing $10,000 before age 59½ from a Traditional IRA would pay a $1,000 penalty, plus applicable income taxes.

Time-Based Savings Accounts

Penalties for early withdrawals from CDs are often calculated based on the interest earned or a fixed number of months' interest.

An example is a 12-month CD with an early withdrawal penalty of three months' interest would result in the loss of a quarter of the total interest earned.

Strategies to Minimize Early Withdrawal Penalties

Retirement Accounts

  • Emergency Funds: Establishing an emergency fund separate from your retirement accounts can help avoid early withdrawals and related penalties.

  • Roth IRA Contributions: Roth IRA contributions can be withdrawn tax-free and penalty-free under certain conditions, making them a more flexible option.

  • Utilizing Exceptions and Exemptions: Familiarize yourself with the available exceptions and exemptions to minimize early withdrawal penalties.

Time-Based Savings Accounts

  • Laddering CDs: Implementing a CD ladder strategy can provide more frequent access to funds while still earning interest, reducing the need for early withdrawals.

  • Selecting Appropriate Terms: Choose CD terms that align with your financial goals and anticipated liquidity needs to avoid early withdrawal penalties.

  • Researching No-Penalty Options: Consider no-penalty CDs or other flexible savings options to ensure easy access to funds without incurring penalties.

Tax Implications of Early Withdrawal Penalties

Retirement Accounts

  • Federal Tax Consequences: Early withdrawals from retirement accounts are generally subject to federal income taxes in addition to penalties.

  • State Tax Consequences: Depending on your state of residence, early withdrawals may also be subject to state income taxes.

Time-Based Savings Accounts

  • Federal Tax Consequences: Although CD early withdrawal penalties may not incur additional federal taxes, the interest earned is generally subject to federal income tax.

  • State Tax Consequences: Interest earned on CDs may also be subject to state income taxes, depending on your state of residence.

Conclusion

Early withdrawal penalties are financial penalties imposed on individuals who withdraw funds from certain types of accounts before a specified age or time period.

Retirement accounts, such as Traditional IRAs, Roth IRAs, and 401(k) plans, are most commonly associated with early withdrawal penalties, but they can also apply to other types of time-based savings accounts, such as Certificates of Deposit (CDs).

Exceptions to early withdrawal penalties exist, such as for specific life events like a first-time home purchase or qualified higher education expenses.

Early withdrawal penalties are calculated differently for retirement accounts and time-based savings accounts, and individuals can minimize these penalties through strategies like establishing emergency funds or choosing appropriate terms.

It is important to keep in mind that early withdrawal penalties may also have tax implications, including federal and state income taxes.

Understanding early withdrawal penalties and how to minimize them can help individuals make informed decisions about their finances and avoid unnecessary penalties and taxes.

Early Withdrawal Penalty FAQs

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About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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