What Is the Penalty for Early Withdrawal on Mutual Funds?

Mutual funds are investment companies that create pools of securities such as stocks and bonds. In theory, mutual funds provide you the opportunity for unlimited growth. But shares held in retirement accounts are subject to penalties for early withdrawal. The extent of the penalties depends on the nature of the account and the reason for the withdrawal.

Premature Withdrawal

You can fund your individual retirement account or 401(k) on a pretax basis, with your account growing tax-deferred. You pay income tax when you make withdrawals. Under the federal tax code, you make an early withdrawal if you sell your shares and access funds before age 59 1/2. In these instances, you typically pay a 10 percent penalty. The penalty rises to 25 percent if you cash in shares in a SIMPLE IRA plan that you have held for less than two years.

Penalty Waiver

You do not have to pay the 10 percent penalty if you redeem your shares because your otherwise-unreimbursed medical costs exceed 7.5 percent of your adjusted gross income. You also can avoid the penalty if you use the cash to cover certain educational costs, to buy a home or if you access funds after becoming disabled. On an employer-sponsored plan, you can make penalty-free but taxable withdrawals if you lose your job after age 55. You can sell shares in your IRA at any time. In contrast, employers are permitted -- but not required -- to allow you to make premature withdrawals from 401(k)s and similar plans while still employed.

After Tax

You buy shares in a Roth IRA with after-tax funds. Likewise, many employer-sponsored retirement plans include a provision for after-tax Roth contributions. You do not pay a penalty when you make an early withdrawal of principal from a Roth. However, you are charged the 10 percent penalty and ordinary income tax on premature withdrawals of your account earnings if the account hasn't been open at least five years. Even within a traditional IRA, you can choose to make after-tax contributions. As with the Roth, you can sell shares bought with your principal without incurring a penalty, but you must pay taxes and penalties on your earnings.

Fees

Aside from premature-withdrawal penalties, you might have to pay mutual fund fees when you sell your shares. A-class mutual funds have an upfront sales charge or load, but you pay nothing to the fund when you redeem your shares. In contrast, B and C class shares have no upfront costs, but you pay a back-end load or sales commission when you sell them. The size of the fee is gradually reduced for each year that you hold your shares, and you avoid it altogether if you keep your shares seven years or more. Even "no-load" funds often assess administrative charges when you sell shares, although these flat fees aren't affected by how long you owned them.

Photo Credits

  • Stockbyte/Stockbyte/Getty Images

Zacks Investment Research

is an A+ Rated BBB

Accredited Business.