The cost of early withdrawal
There’s a cost to withdrawing your money prematurely. This price is clear with some investments, but not with all of them. Here’s how it works with the main investment groups.
Investment decisions are often hastily made. High returns are promised and we take the bait, regardless of how long it may take to achieve the advertised returns. As you may have experienced, situations may require you to break your investments earlier than you planned. In these cases, you may end up losing more than you expect. The following list will tell you the price of quitting a scheme too early.
Most people think there only is a withdrawal penalty when you break a fixed deposit before its maturity date. But there are two costs. Aside from the penalty, which usually is 1% of the deposit, the rate of interest that will be paid to you will be adjusted. Let’s understand this with the following example: if you lock your money into a fixed deposit offering an interest rate of 9% for one year, but wish to withdraw your money six months later, you shall receive the money at the rate applicable to six-month deposits (which is usually lower), not one-year deposits. Therefore, if you put money in at say, 9.5% for three years, but withdraw in six months, you would receive interest at say, 7% per annum, after deduction of 1% of your deposit as a penalty. A few banks, however, charge no penalty.
There is ample evidence that insurance agents will lie to sell their products. One of the lies they sell is that unit-linked insurance products and endowment plans have the ability to turn a profit early on. This is unlikely, as both are structured to deliver returns in the second half of the term, if at all. With ULIPs, the problem is high costs, which impairs the ability of the fund to deliver good returns even if the market is doing well. Therefore, even though the lock-in ends in five years, the low or negative returns may force you to stay with the scheme for a few years longer. With endowment plans, on the other hand, the problem is low returns, until bonuses are paid out toward the end of the plan.
Mutual funds have no lock-in period. However, it’s best to take a long-term view with equity funds and increasingly, debt funds, too. What is exactly a long-term view seems to change with time, but equity funds are generally preferred when you have no reason to withdraw your investment for at least five to seven years. With debt funds, this could be three to five years. Aside from the fact that your investment may not have provided even decent returns before this time, there’s also the question of tax liability. With mutual funds, thankfully, the Income Tax Act is quite lenient. Find out the cost of early withdrawal from a tax perspective here.
Tax-free bonds pay a good return, but usually have tenures of 10, 15 and 20 years. So if you have a long-term view, they’re most definitely a great investment. But don’t run to invest here if liquidity is a priority. This is because exiting early would strip the investment of its tax benefits and if trading volumes are low, you may be selling at a discount. If you aren’t sure whether you’ll need the money beforehand, only invest in companies whose bonds are given the highest rating.
Pension plans aren’t only the unit-linked plans sold by insurers. They include New Pension Scheme or NPS and Employees Provident Fund or EPF. With all three, the lock-in is until retirement. Now, you are allowed early withdrawal, but usually at a cost. In the case of NPS, withdrawals before 60 are discouraged. You do have the option of withdrawing your funds from the NPS before turning 60, but if you do dip into the fund, a whopping 80% of what’s left will have to be invested in the annuity. The case is similar for unit-linked pension plans, which require you to annuitize 2/3rds of the fund if you have to withdraw any amount before retirement. Therefore, before investing in a pension plan, always consider whether you can handle this inflexibility.