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What is an early withdrawal penalty?
An early withdrawal penalty is assessed when a depositor withdraws funds from or closes out a time deposit before its maturity date. Early withdrawal penalties exist to discourage investors from removing funds early from deposit accounts.
When investors put money into investment accounts, deposit accounts or different funds, the institutions holding the funds reinvest them elsewhere to make a profit. Investors who demand their money back early potentially jeopardize the bank’s ability to fulfill other loan obligations. The early withdrawal penalty is a tool to help firms retain the funds they rely on.
Early withdrawal penalties are usually charged against accounts that rely on some designation of fixed maturity, like the expiration of a certain time period. Individual retirement accounts (IRAs), 401(k)s and certificates of deposit are the most common investments that carry early withdrawal penalties.
Occasionally, there are special circumstances in which early withdrawal penalties are waived or removed for investors who qualify. Withdrawing investment funds early to pay a high medical expense or make a qualifying home purchase is enough to get an early withdrawal penalty fee waived. But requirements can vary significantly from one financial institution to the next.
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Early withdrawal penalty example
John, 42, has $50,000 in a 401(k) account through his employer. John wants to take a European vacation and decides to withdraw $5,000 from the account. Because he is not 59 1/2 years old, the federal government charges him an early withdrawal penalty of 10 percent. So, John is penalized $500. In addition, he will have to pay taxes on the $5,000 when he files his taxes for that year.