A withdrawal penalty is a charge assessed if money is taken out of an investment account prior to maturity. Withdrawal penalties are most commonly features of certificates of deposit, mutual fund shares, annuities and retirement planning accounts.
Withdrawal Penalty on a Certificate of Deposit
Certificates of deposit (CDs) incur a withdrawal penalty if money is taken out prior to the CD’s maturity. The penalty is usually six months’ interest. If the account has not been active long enough to have earned this much interest, the penalty can be taken out of the principal.
Once the CD matures, the entire amount may be withdrawn without any penalty.
A common strategy for CD investors with liquidity needs is ‘laddering’. This involves purchasing multiple CDs with different maturities in order to free up capital at certain intervals. Instead of putting $100,000 into a 10-year CD, a laddered strategy might put $10,000 in a 1-year CD, $10,000 in a 2-year CD, $10,000 in a 3-year CD, etc.; and that way, an additional $10,000 would be free and clear of withdrawal penalties each year.
Withdrawal Penalty on Annuities and Mutual Fund Shares
For mutual fund shares and deferred annuities with back-end loads, a withdrawal penalty may be applied if money is withdrawn from these accounts before a period of years, known as the ‘surrender schedule’, has elapsed.
The withdrawal penalty on these types of investments is typically expressed as a percentage of the amount withdrawn. The percentage declines each year until it reaches zero.
A five-year surrender schedule, for example, might begin at 5%, decreasing by 1% per year until it reaches zero in year six.
Many annuities have a ‘free amount’ that may be withdrawn each year without penalty. 10% of the contract value per year is a common free amount, but it varies by product and issuer.
One the surrender schedule is over, no further sales charges are due, although annual operating expenses may apply.
Tax Penalty on Premature Withdrawals
For retirement planning accounts such as individual retirement accounts (IRAs) and 401(k)’s, the IRS imposes a penalty of their own for withdrawals they consider to be premature.
In addition to whatever ordinary tax that is due on withdrawals from an IRA or 401(k), withdrawals before the investor reaches age 59½ are subject to a 10% tax penalty.
There are ways around this but they are limited to extenuating circumstances such as disability or other hardships.
Planning around Withdrawal Penalties
Your liquidity needs and investment time horizon will have a bearing on the suitability of investments with withdrawal penalties.
If you are investing money that you are certain you won’t need to use until after the investment matures, then a withdrawal penalty may not be an issue for you.
You may want to allocate the portion of your money that you will need in the near future to instruments that have short-term or no withdrawal penalty. Short-term bonds, money market instruments, and C-share mutual funds are examples of these types of investments.
