An early withdrawal is a removal of funds from an investment or account that is not yet mature. When people withdraw funds prior to an account's maturity, they can be penalized for it. In addition to paying fees to the financial institution that holds the account, account holders may also face tax penalties. For these reasons, early withdrawal is generally discouraged unless there is a compelling reason for it.
In the case of fixed term investments such as certificates of deposit, an arrangement between the client and financial institution is made. The financial institution accesses the right to use the client's money for the duration of the investment, while the client is entitled to interest in return. By withdrawing money early, the client is breaking the contract. The financial institution can charge a penalty fee to compensate for the broken contract and the administrative costs associated with processing the early withdrawal.
For retirement accounts, early withdrawal usually results in penalty fees from the financial institution as well as tax penalties. Retirement accounts are designed as tax-deferred accounts, allowing people to divert income into a retirement account without paying taxes on the income. When people take that income out early, tax agencies can come knocking and the financial institution will also extract its own penalty fees. As a result, such withdrawals can create a significant loss.
There are certain circumstances in which early withdrawal from a retirement account will not be penalized. People who can show a pressing need such as paying for college or financing the purchase of a first home can qualify for a hardship withdrawal. In this case, no penalty is incurred for premature distribution of funds because it is understood that the account holder had a legitimate and immediate need for those funds.
When establishing retirement accounts and other fixed term investments, clients must be informed in advance about what will happen if they make an early withdrawal. Opening such accounts is usually not recommended if a client has a concern about the need to access the money before the term of the account is up. People are also strongly encouraged to find other ways of funding emergencies so that they do not take money which should be earning and compounding interest out of an investment account. This results in long term losses for the individual, as well as the short term penalties associated with early withdrawal.