What is a Withdrawal Penalty?

A withdrawal penalty occurs when a depositor or investor withdraws funds from an account before an agreed-upon withdrawal date for disallowed purposes or in a disallowed manner.

How Does a Withdrawal Penalty Work?

Individual retirement accounts (IRAs) are one type of investment often associated with withdrawal penalties. Typically, a person with an IRA deposits money into the account over a period of time and then must wait until age 59 1/2 to withdraw funds. If the investor withdraws funds before this age, he or she must pay a 10% early withdrawal penalty (as well as taxes) on the distribution. Other retirement vehicles, such as 401(k)s, carry early withdrawal penalties as well. Certificates of deposit (CDs) have similar penalties for early withdrawal, though these securities often mature in just a few months or years.

Why Does a Withdrawal Penalty Matter?

When an investor gives money to an institution, the institution often uses that money for other purposes for the duration of the investment period (a bank, for example, will often lend money it receives from CD investors to other customers; if the CD investor requests an early withdrawal, the bank may be in theory less able to fulfill its loan commitments to other customers). Thus, institutions implement early withdrawal penalties to encourage investors to stick to their agreements. Of course, if the investor can earn a return elsewhere that exceeds the investment's rate of return plus all the withdrawal penalties, then the investor might withdraw early anyway.

Nevertheless, early withdrawal is usually a bad thing in the investment world, though there are some circumstances in which investors can withdraw funds early without incurring penalties. These exceptions vary by instrument and institution, but they generally include things such as education expenses, disability, very high medical expenses, some home purchases, military service, and needs after a natural disaster.