What it is:
Early withdrawal refers to a depositor's or investor's withdrawal of funds from an account before the agreed-upon withdrawal date. Early withdrawals usually incur penalties.
How it works (Example):
Individual retirement accounts (IRAs) are one type of investment often associated with early withdrawals.
Typically, a person deposits money into an IRA over a period of time and then must wait until age 59 1/2 to withdraw funds. If the investor withdraws funds early, 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 it Matters:
When an investor deposits money into an account at a banking or brokerage 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.
Investors can sometimes avoid early withdrawal penalties by meeting certain requirements. 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.