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Understanding How an Early Withdrawal Penalty Works


By Shen Lu

When you need cash for an emergency but don’t have enough in your “liquid” savings accounts, a bank certificate of deposit, known as a CD, or your retirement account may look like attractive targets. But funds in these accounts are typically locked up for a certain period of time and tapping them early generally comes with penalties.

These early withdrawal penalties can be significant, based on the specified account’s terms and conditions. But there are cases where it’s worth taking the penalty in exchange for better returns. We will walk you through how an early withdrawal penalty works, how to avoid it and when it makes sense to take it.

Products that impose an early withdrawal penalty

In the realm of deposit accounts, the early withdrawal penalty typically applies to CDs.

CDs

You buy CDs from financial institutions with a set amount of money for a specific time ranging from days to years. Closing a CD before its maturity can result in early withdrawal penalties. On average, the longer the CD term, the bigger the early withdrawal penalty, said Ken Tumin, founder and editor of DepositAccounts.com.

Typical cost of a CD early withdrawal penalty

A typical early withdrawal penalty cuts into any interest you may have earned, but if your penalty is greater than the amount of interest earned, it could even take away from your principal. Tumin said about 80% of banks and credit unions use this standard early withdrawal penalty.

For instance, Marcus by Goldman Sachs follows the early withdrawal penalties below:

CD Term Early Withdrawal
Less than 12 months 90 days’ interest
12 months to 5 years 270 days’ interest
More than 5 years 365 days’ interest

Marcus does not allow clients to withdraw a portion of their principal at any time prior to maturity. The early withdrawal penalty is calculated on the total balance of the account.

Same with Ally Bank, whose early withdrawal penalty schedule is a bit different:

CD Term Early Withdrawal
24 months or less 60 days’ interest
25 months – 36 months 90 days’ interest
37 months – 48 months 120 days’ interest
49 months or longer 150 days’ interest

Not all banks use this simple early withdrawal penalty method. Tumin said about 20% of banks and credit unions apply more complex early withdrawal penalty formulas.

The following are a few examples of more complex early withdrawal penalties:

  1. Specified number of days’ interest plus a flat fee
  2. Specified number of days’ interest, additional flat fee and cancellation of the CD
  3. Specified percentage of the principal
  4. Specified percentage of the amount withdrawn

Chase Bank, for example, uses the No.4 method on the list:

CD Term Early Withdrawal
Less than 24 months 1% of the amount withdrawn, but not more than the total amount of interest earned during the current term of the CD
24 months+ 2% of the amount withdrawn, but not more than the total amount of interest earned during the current term of the CD

How to calculate an early withdrawal penalty on a CD

  1. If your bank calculates the penalty on the entire balance on a daily basis (like Marcus and Ally), then use this formula:

    Penalty = (account balance x interest rate)/(365 days) x # of days’ interest

    For example, if you withdraw $5,000 early from a 12-month Ally CD with a 2% interest rate, the penalty would be $16.40 — ($5,000 x 2%)/(365) x 60 days

  1. If your bank calculates the penalty on the entire deposit as months’ interest (like Wells Fargo), then the formula is slightly different:

    Penalty = (account balance x interest rate)/(12 months) x number of months’ interest

    For example, if you have a $10,000 CD for 12 months at 2% of interest rate, $10,000 could grow $200 of interest for a year. Say an early withdrawal could cost you six months of interest, which is 1/2 of that, or $100. If you close your CD before maturity, no matter how far in advance, that $100 will be deducted from the interest that you have earned on your deposit.

  1. If your bank calculates the penalty on the amount of money you withdraw (like Chase) or on the principal, then the formulas is as follows:

    Penalty = amount withdrawn x percentage

    Penalty = account balance x percentage

    Say you’ve invested $10,000 in a CD whose early withdrawal penalty comes at 1% of the money you take out — if you withdraw $5,000, your penalty would be $5,000 x 1%= $50. If the penalty is calculated on the total account balance, you’d lose $100.

You can use our calculator to calculate early withdrawal penalties applied in different CD products.

CD early withdrawal penalty exceptions

However, not all early withdrawals result in penalties. Under certain circumstances, such penalties are waived:

  1. Death of the CD holder. The beneficiary designated by the account holder will be able to receive funds without paying an early withdrawal penalty.
  2. Disability or legal incapacity of a CD owner. If a court has determined that a CD holder is incompetent, then he or she is exempt from early withdrawal penalties.
  3. Required minimum distributions from an IRA CD. An IRA CD operates in much the same way as any other CD plus the tax benefits you receive from an Individual Retirement Account (IRA). And like you would with any traditional IRA, the IRS requires owners to start collecting distributions by April after your 70½ birthday, so most banks waive any penalties. How much you draw depends on estimated life expectancy and the value of your account.

How to avoid incurring a CD early withdrawal penalty

CDs that offer higher rates generally have longer terms and bigger early withdrawal penalties.

For those who need funds for expenses that may come up soon, it’s probably not a good idea to lock up all your savings in a CD for an extended period of time.

There are a few common strategies to avoid early withdrawal penalties:

  1. Opt for other deposit accounts

    To avoid an early withdrawal penalty, stash money in a money market or high-yield savings account that doesn’t apply an early withdrawal penalty. Or, select a no-penalty CD. With a no-penalty CD, you won’t lose accrued interest if you withdraw funds early, but you still enjoy the benefits of a high-yield deposit account (albeit with an interest rate typically a bit lower than traditional CDs).

  1. Build a CD “ladder”

    Another common strategy to avoid that early withdrawal penalty is CD laddering. A CD ladder is a series of multiple CDs with varying terms. By laddering them, you may take advantage of higher rates while maintaining access to your funds.

    Here is how it works: Invest funds in short-, medium - and long-term CDs that mature at different times. When you need cash, you can withdraw without penalty at maturity of the short-term CD. Or, if you don’t need it, reinvest the money to a longer-term CD to earn more interest.

When it’s worth incurring the early withdrawal penalty

Sometimes an early closure of your CD can be advantageous.

This scenario happens when you are invested in a low-rate CD but rates have meanwhile gone up. It can make sense to go ahead and close that old CD, take the early withdrawal penalty and redeploy the money into a higher rate account. This way, you could earn more interest than just keeping the old CD until maturity, Tumin said.

To assess which way you would be better off, take the current rate of the CD and calculate how much interest you would earn on the CD until maturity. Say you have 12 months left on a 2% CD deposit of $5,000, and we come up with $100. Then, determine how much interest you would earn from that higher-rate CD (say it’s at 3%) for 12 months — $150 — and subtract the early withdrawal penalty. Let’s say it would be $25 in the case of cutting three months’ interest earned. In this case, you would earn $25 more if you open a new CD account. Therefore, it makes sense in this case to take the early withdrawal penalty.

You can use our calculator to determine when it’s worth paying the early withdrawal penalty to close a CD.

Retirement accounts

An early withdrawal penalty is also likely to come up in retirement plans. The most common retirement accounts are defined contribution plans that often allow you to invest pretax dollars in an account that grows tax-free until a person takes a distribution. Or, you may have a Roth IRA, which allows you to contribute post-tax dollars.

Both plans come with fine print. If you take an early withdrawal from your retirement plan, you typically have to pay an early withdrawal penalty, unless you qualify for an exception to the early withdrawal penalties.

IRAs

The cost of withdrawing from an IRA early

An IRA is an individual retirement account. If you are under age 59½ and you take money out of your IRA, the IRS considers this transaction as an early withdrawal. An early withdrawal, known as an early distribution, comes with tax and penalty consequences, which may vary by retirement account types (traditional or Roth).

A traditional IRA allows you to defer income taxes until you take a distribution. A Roth IRA lets participants invest after-tax dollars so they won’t have to pay taxes upon withdrawal.

Unless you qualify for an exception to the early withdrawal penalties depending on your situation, you will have to pay a 10% early withdrawal penalty and be taxed on the amount of money you withdraw if it’s a traditional IRA.

Let’s assume you’re 35 and in the 25% tax bracket. If you take $10,000 from your traditional IRA, you will have to pay income tax of $2,500 and an additional penalty for early withdrawal of $1,000. This early withdrawal will cost you $3,500.

In the case of a Roth, you don’t have to pay an income tax when taking out the $10,000 because you’ve contributed after-tax funds to your account. The early withdrawal fee would be $1,000.

Exceptions to an early withdrawal penalty on an IRA

While most early distributions are subject to a10% fee and may be taxed, too, there are exceptions. Below are the common situations where participants will be exempt from early IRA withdrawal penalties:

  1. You withdraw funds to cover unreimbursed medical expenses that exceed 10% of your adjusted gross income (7.5% if you are age 65 or older).
  2. Your withdrawal is to pay medical insurance premium costs while unemployed.
  3. You pay qualified higher education expenses with your distribution.
  4. You withdraw money to buy your first home (up to $10,000).
  5. Your withdrawal is a qualified reservist distribution, meaning you are a member of a military Reserve unit called to active duty.
  6. You are disabled.
  7. You are the beneficiary of an IRA owner who died.
  8. The withdrawal is the result of an IRS levy.

The IRS publishes a complete list of qualified exceptions to the early withdrawal penalty.

How to avoid the IRA early withdrawal penalty

Taking an early distribution from your IRA comes with financial pitfalls, and it’s not easy to replenish your account after a withdrawal. But when you need cash and don’t have other liquid savings or checkings accounts to tap, the best way to take an early withdrawal while avoiding the 10% penalty is to see if you can take a qualified early distribution, meaning that you fit into an exception discussed in the sections above.

401(k)

The cost of withdrawing from a 401(k) early

A 401(k) is an employer-sponsored retirement account. The consequences to moving funds from 401(k)s before age 59 ½ are the same as traditional IRAs: You will pay taxes on the amount withdrawn, plus an additional 10% penalty.

Exceptions to an early withdrawal penalty on a 401(k)

Some common circumstances where an early 401(k) distribution won’t be subject to the 10% additional penalty:

  1. You withdraw funds to cover unreimbursed medical expenses that exceed 10% of your adjusted gross income (7.5% if you are age 65 or older).
  2. Your withdrawal is a qualified reservist distribution.
  3. You are disabled.
  4. You are the beneficiary of a 401(k) owner who died.
  5. The withdrawal is the result of an IRS levy.
  6. You separate from public safety service during or after the year you reach age 55 (age 50 for public safety employees of a state).

Refer to this complete list of qualified exceptions to the 401(k) early withdrawal penalty for more exceptions.

How to avoid the 401(k) early withdrawal penalty

Much like an IRA, the best way to take an early withdrawal from your 401(k) while avoiding the 10% penalty is to see if you can take a qualified early distribution, meaning that you fit into an exception to the 401(k) penalty rule.

403(b)

The cost of withdrawing from a 403(b) early

A 403(b) is a retirement account designed for those who work for public schools and nonprofit organizations. It operates similarly to a 401(k), which is for corporate workers. The consequences of moving funds from 403(b) plans before age 59½ are the same as 401(k)s: you will pay income taxes on the amount withdrawn, plus an additional 10% penalty.

Exceptions to an early withdrawal penalty on a 403(b)

In general, the tax rules apply to withdrawals from 403(b) plans are the same as distributions from other retirement plans.

An early distribution made from a 403(b) account won’t be subject to penalties if the account holder:

  1. Has a severance from employment
  2. Dies
  3. Becomes disabled
  4. In the case of elective deferrals, encounters financial hardship
  5. Has a qualified reservist distribution.

How to avoid the 403(b) early withdrawal penalty

The best way to take an early withdrawal from your 403(b) while avoiding the 10% penalty is to see if you can take any of the five qualified distributions.

SIMPLE IRA

The cost of withdrawing from a SIMPLE IRA early

A SIMPLE IRA plan, or Savings Incentive Match Plan for Employees, is a type of traditional IRA for small businesses and start-ups.

Like other IRAs, SIMPLE IRA participants also have to pay a 10% penalty on an early withdrawal unless they are 59½. And the penalty is increased to 25% when the account is less than two years old.

Exceptions to an early withdrawal penalty on a SIMPLE IRA

Exceptions to early withdrawal penalties exist with SIMPLE IRAS in the following circumstances:

  1. You withdraw funds to cover unreimbursed medical expenses that exceed 10% of your adjusted gross income (7.5% if you are age 65 or older).
  2. Your withdrawal is to pay medical insurance premium costs while unemployed.
  3. You pay qualified higher education expenses with your distribution.
  4. You withdraw money to buy your first home (up to $10,000).
  5. Your withdrawal is in the form of an annuity.
  6. Your withdrawal is a qualified reservist distribution.
  7. You are disabled.
  8. You are the beneficiary of a SIMPLE IRA owner who died.
  9. The withdrawal is the result of an IRS levy.

Refer to this complete list of qualified exceptions to the SIMPLE IRA early withdrawal penalty for more exceptions.

How to avoid the SIMPLE IRA early withdrawal penalty

The best way to take an early withdrawal from your SIMPLE IRA while avoiding a penalty is to see if you can take a qualified distribution under any of the circumstances in the section above.

SEP IRA

The cost of withdrawing from a SEP IRA early

A SEP is a Simplified Employee Pension plan, a simplified IRA plan often used by self-employed workers or small business owners. Just like other IRA accounts, an early withdrawal before you are 59½ years old would result in a 10% penalty unless you qualify for an exception to the penalty.

Exceptions to an early withdrawal penalty on a SEP IRA

Exceptions to early withdrawal penalties exist with SEP IRAs in the following circumstances:

  1. You withdraw funds to cover unreimbursed medical expenses that exceed 10% of your adjusted gross income (7.5% if you are age 65 or older).
  2. Your withdrawal is to pay medical insurance premium costs while unemployed.
  3. You pay qualified higher education expenses with your distribution.
  4. You withdraw money to buy your first home (up to $10,000).
  5. Your withdrawal is a qualified reservist distribution.
  6. You are disabled.
  7. You are the beneficiary of a SEP IRA owner who died.
  8. The withdrawal is the result of an IRS levy.

Refer to this complete list of qualified exceptions to the SEP IRA early withdrawal penalty for more exceptions.

How to avoid the SEP IRA early withdrawal penalty

The best way to take an early withdrawal from your SEP IRA while avoiding a penalty is to see if you can take a qualified distribution under any of the circumstances in the section above.

Comments
Amos
Amos   |     |   Comment #2
Excellent article.
stnemmoc
stnemmoc   |     |   Comment #3
though it's minor, an ewp used to also be tax deductable, at least in the past. not much help, but if you inccur one at least in a taxable acct (don't know about ira) at least let your tax person know. in the past there were situations where it was deductable (like a business expense or charity contribution is tax deductable). I don't know details but check w/you tax person.
Ann
Ann   |     |   Comment #10
It still is. It just doesn't gain you anything overall. Your CD's 1099s reports the total amount of interest distributed to you, even if you had to give some of it back as an EWP. So you get to subtract the EWP from your income, so you don't get taxed on income you didn't really get.
MJSR71
MJSR71   |     |   Comment #38
You got it, but it is not like a charity deduction (as described by stnemmoc). It is as you described, an ADJUSTMENT to income, and as such benefits all taxpayers (meaning you do not have to itemize).
Prometheus
Prometheus   |     |   Comment #4
For persons with IRA funds invested in a CD, and wanting to close the CD prior to maturity and pay the EWP, there is this "gotcha":

The IRS requires the EWP be paid from IRA funds. These are, of course, oftentimes tax-advantaged funds. It would be preferable to pay the EWP out of money not inside your IRA. And the financial institution receives its EWP money, the same amount of money, either way. But the IRS has its rules.

My own personal approach would be to attempt, regardless, to pay the penalty using funds outside the IRA, relying on the likelihood that your financial institution is unaware of this IRS rule. Worst that can happen would be for them to say "no".
Nothing
Nothing   |     |   Comment #5
To me, the difference between EWP for taxes, e.g. 591/2 and EWP to CD issuer for after 65, and after 701/2 is not clear to reader. And the benefit of QCDs after 701/2 is not clear
??
??   |     |   Comment #17
Ann - For further "clarification" see comment #3 of the 7/24/2018 Bank Deals Blog "CD Bank Offers 24-Month CD (3.00% APY) Nationwide"
RJM
RJM   |     |   Comment #6
I have a 5 year CD I will be closing soon. But I find its not always that simple because the penalty calculator has its limitations.

For example, I have a 2.25% 5 year at Ally with about 46.5 months left. I know the penalty is 150 days.

However the calculator assumes I will be buying another 5 year and I probably don't want to do that yet. (looking to stay at or under 36 months) Since 2.25% is close to my top money market account at 2.26%, I don't see a huge hurry to close it just yet. I'm fairly certain I will in the next few months as better deals come up.

Is my thinking sound or should I close it even if I don't have an immediate place to put the money right now?

I know when I decide to do it, its quick & easy and will be immediately available for transfer out.

I have said before, a 3% one year, 3.25% 18 month or 3.50% 2 year are kind of what I am looking for. There is a current 18 month available at 3.15% and its close to what I am looking for except for the no ach out.

I already have a 2.75% Andrews 9 month CD and can't double up there. (Limit of one per person)

I have more CDs maturing ...one tuesday and then more near year end and just after year end with more in early Feb.

Hopefully when those roll around I will have some good intermediate term choices.
deplorable 1
deplorable 1   |     |   Comment #8
I would not close a CD early and take a penalty unless:
1. Your liquid cash account is paying .5% more than the CD.
2. You have another CD lined up that pays at least 1% more.
3. The EWP is 6 months interest or less and you have 24 month or more left to go.
So far I have been lucky and never needed to break a CD early.
deplorable 1
deplorable 1   |     |   Comment #9
Looking at your 2.25% CD with 46.5 months left. I think you will need to break it within a year as rates on liquid savings will be 2.5%-2.75% APY and 1-2 year CD's will be at least 3.25%. If you break it today and stick it into savings you will just be losing money so no point.
deplorable 1
deplorable 1   |     |   Comment #7
Can't you withdraw your CONTRIBUTIONS to a Roth IRA tax and penalty free at any time even if you are not 59.5? I think the Roth IRA must be 5 years old before you can do this though.
Ann
Ann   |     |   Comment #12
https://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/roth_ira/withdrawal_rules says there is no 5-year rule for withdrawing Roth contributions. That's only a factor if you're withdrawing more than your contribution total.
deplorable 1
deplorable 1   |     |   Comment #15
Thanks Ann that's even better than I thought! Although you are still better off not taking withdrawals it's nice to know that the option exists.
Rico
Rico   |     |   Comment #16
The analysis CD EWP is ok as far as it goes. However, there are additional possible alternatives that could be save money. 1. While these are becoming rare, a savings or CD secured loan may
(depending on the duration) in the end cost less in loan interest than a CD penalty. This may be an
option if the CD is nearing maturity. 2. A home equity line of credit may also work the same way if the need for funds is a short period. Calculate the CD penalty cost against the interest expense on either of the two above options. The borrowing option could make even more sense if the CD penalty is assessed against the entire balance, regardless of the amount withdrawn.
deplorable 1
deplorable 1   |     |   Comment #19
Taking out a loan is a losing proposition in most cases. Why even pay interest on a short term loan at all? Just open up a credit card that has a 0% no fee balance transfer for 15 months. This has nothing to do with the timing of a early withdrawal of a CD though.
spentcattle
spentcattle   |     |   Comment #24
Just wondered what are peoples thoughts on five year CD rates and where they will go in next few months in terms of locking in particularly with modest penalties. We are seeing more 3.5's
deplorable 1
deplorable 1   |     |   Comment #25
I would venture to guess 4% by the end of this year and 5% by the end of next year on 5 year CD's. Obviously this all hinges on the continuing strong economic growth/inflation and no crazy stock market drops. Also on what happens with interest rates globally as this seems to effect FED decisions as well as long term treasuries.
Big Words
Big Words   |     |   Comment #26
Wow, THANKS!

Go big or GO HOME!!!
RickZ
RickZ   |     |   Comment #29
For the last couple of years I’ve followed the online comments of a currency trader and PhD mathematician named Erwin Witt. Erwin posts his comments on a couple of investment and gold sites which is where I found his writings. He has been very accurate in his calls over the last two years - for example, he called the top in gold at 1361 over two years ago and thinks that will hold at least through 2019.

This is what he wrote yesterday, July 31, 2018:

“QualVar econometric analysis of the US economy now suggests that Q2 US GDP will be revised upward in the coming revisions resulting in Q1+Q2

The current Fed Funds Rate is 2.0%, the 10-year note closed today at 2.97% and the highest nationally available 5-year CDs are 3.37% at KS StateBank followed by 3.30% at CommunityWide FCU. I’m no expert on this so please draw your own conclusions, but it seems to me that if Erwin's projections are correct and the Fed Funds Rate increases by 1.25% and the 10-year note increases by 1.18% then we’d be looking at a 5-year CD at around 4.5%-4.6% at the end of 2019.
RickZ
RickZ   |     |   Comment #30
For some reason the quote was cut-off.

This is what he wrote yesterday, July 31, 2018:

"QualVar econometric analysis of the US economy now suggests that Q2 US GDP will be revised upward in the coming revisions resulting in Q1 + Q2 = 3.2%. QualVar analysis now projects US Q3 GDP will come in = 3.2% with the Fed Funds rate at 2.5% by December 31, 2018 and 3.25% by December 31, 2019. The yield on the 10 US T-Note is now projected to be 4.15% by December, 31, 2019. In conclusion, US GDP growth is projected to average 2.9% for 2018 and 2019. The effective Fed funds rate will be 3.15% by the end of 2019.”
RickZ
RickZ   |     |   Comment #31
Ugh! Why no edit function anymore? Meant to say: This is what he wrote today, July 30, 2018.
deplorable 1
deplorable 1   |     |   Comment #32
That pretty much falls in line with my prediction. Just for clarification when I say 4% by the end of 2018 and 5% by the end of 2019 I'm not referring to the average 5 year CD rate but the top payers, specials and local deals that will be available at that time.
larry
larry   |     |   Comment #33
Yep, I'm on board with that also. Keeping all our investments short and sweet. Our 2.05% one month CD matured today, so I was looking around and now the best deal is 1.82% for a one month and we went with that in our brokerage account. I see the callable CD rates are starting to creep up on the 5 yr ones.
robert
robert   |     |   Comment #35
would you please add a link to the comments for Erwin Witt.
Luvcd
Luvcd   |     |   Comment #36
In the past when "you" were "removed" you were/are toast....Been there, done that. OR...
RickZ
RickZ   |     |   Comment #37
I follow him on disqus.com
lrdxgm
lrdxgm   |     |   Comment #21
One small error in the article: early withdrawals (before age 59.5, without exception) from a Roth IRA (or 401k) are *not* subject to the 10% penalty up to the contribution amounts. In the example of a $10000 contribution, all of that $10000 is withdraw-able tax and penalty free; you would only need to pay income tax and 10% penalty on earnings. And if you withdraw less than $10000 before age 59.5, you are never paying that penalty. (Unless tax laws change..)
lou
lou   |     |   Comment #27
This is wrong with respect to the 401k account. There is always a 10% penalty before 59.5 except for certain hardship exceptions.
lou
lou   |     |   Comment #28
Well, unless it's a Roth 401K, which is what I think he means.
Lrdx
Lrdx   |     |   Comment #34
I meant Roth IRA or Roth 401k

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