What is an Early Withdrawal Penalty?

An early withdrawal penalty is a fee charged by the government or a financial institution when an investor withdraws money from long-term investment plans before they have matured. These fees apply to two different kinds of investments: tax-deferred retirement plans and certificates of deposit (CD). Roth IRAs, annuities, and 401k or 403b plans are all examples of tax-deferred retirement plans subject to early withdrawal penalty.

Most government-sanctioned retirement plans follow the same basic guidelines. A beneficiary must have reached the age of 59.5 in order to withdraw money from a Roth IRA, annuity, 401k, or 403b. If for some reason the beneficiary chooses to withdraw the money before reaching age 59.5, the beneficiary will be charged an early withdrawal penalty fee of 10 percent of the value of the investment. In addition, the beneficiary will be expected to pay taxes on the money that has been withdrawn.

Certain exceptions exist under which the beneficiary may not have to pay the early withdrawal penalty. For example, if the beneficiary dies, the investment will be paid out to the spouse or other family member without penalty. Also, if the beneficiary becomes ill and needs money for medical expenses that add up to 7.5 percent more than the beneficiary makes in a year, it is possible to make a medical expense deduction without paying the early withdrawal penalty. Other exceptions may also apply.

A CD is much like a savings account in that it is insured and almost risk free. The difference is that, once money is deposited in the CD, the bank or other financial institution expects it to stay there for an agreed upon amount of time. In return, the bank agrees to pay the investor a higher interest rate than what it pays on savings accounts. CD terms vary from three months to five years. If money is withdrawn before the contracted time has elapsed, the investor will be charged an early withdrawal penalty.

The amount of the early withdrawal penalty varies from bank to bank. There is no federally mandated maximum penalty. Usually withdrawal penalties are based on the CD interest. For example, a bank may charge three months of interest for early withdrawals on a year-long CD.

Some contracts may allow the bank to invade the principle. This means that if the penalty fee is three months of interest and the investor takes money out of the CD at two months, the bank can take the rest of the money out of the principle.