Can I Cancel My Annuity? How to Do It and What to Expect

An annuity is a financial contract established with an insurance company, primarily designed to provide a steady income stream, often for retirement. These contracts allow assets to grow on a tax-deferred basis, meaning earnings are not taxed until funds are withdrawn. While annuities are structured for long-term financial planning, various life circumstances can lead individuals to consider ending their contract prematurely. This process involves specific procedures and financial considerations.

Understanding Annuity Surrender

Ending an annuity contract before its full term is commonly referred to as surrendering the annuity. Annuities are generally designed as long-term savings vehicles, and their contracts often include provisions that limit immediate access to the invested funds. These liquidity restrictions are put in place because the insurance company invests the premiums received with the expectation of holding those funds for an extended period to generate returns.

Upon the initial purchase of an annuity, a “free look” period is typically provided, allowing the purchaser to review the contract and cancel it without penalty. This period usually ranges from 10 to 30 days after the contract is delivered. If an annuity is canceled during this free look period, the individual generally receives a full refund of the premium paid, without incurring any fees or surrender charges. However, surrendering an annuity after this initial free look period means exchanging the contract for its current cash value, which often involves significant costs.

Surrender Charges and Fees

When an annuity is surrendered outside of the free look period, insurance companies typically impose surrender charges. These charges are a mechanism for the insurer to recover costs associated with the sale and administration of the annuity, including sales commissions paid to agents.

The surrender charge period can vary significantly, often ranging from five to over ten years from the date of purchase. For example, a common surrender charge schedule might be 7% in the first year, declining by one percentage point each subsequent year until it reaches zero. This means that surrendering an annuity earlier in its term will generally result in higher charges. For certain types of annuities, such as fixed indexed annuities, a Market Value Adjustment (MVA) may also apply. An MVA can either increase or decrease the surrender value based on changes in interest rates since the annuity was purchased, further impacting the amount received upon surrender.

Tax Implications of Annuity Surrender

Surrendering an annuity has specific tax consequences that depend on how the annuity was funded. Annuities are generally categorized as either “qualified” or “non-qualified.” Qualified annuities are typically held within tax-advantaged retirement accounts, such as Individual Retirement Accounts (IRAs) or 403(b) plans, and are funded with pre-tax contributions. When a qualified annuity is surrendered, the entire distribution is usually taxable as ordinary income, as the original contributions were not previously taxed.

Non-qualified annuities are purchased with after-tax money. For these annuities, the Internal Revenue Service (IRS) applies the “Last-In, First-Out” (LIFO) rule for taxation, meaning that any earnings are considered to be withdrawn first and are taxed as ordinary income. Only after all earnings have been withdrawn is the return of the original principal (cost basis) considered, which is not taxable.

Additionally, for both qualified and non-qualified annuities, withdrawals made before age 59½ may be subject to a 10% federal income tax penalty, as outlined in Section 72(q), unless a specific exception applies. Exceptions include distributions made due to the annuitant’s death, disability, or a series of substantially equal periodic payments. Upon surrender, the annuity owner will receive Form 1099-R, which reports the distribution amount and any federal tax withheld.

Alternatives to Full Annuity Surrender

Individuals needing access to funds or wishing to change their annuity without incurring the full costs of a complete surrender have several alternatives. Many annuity contracts permit partial withdrawals, allowing the annuitant to access a portion of their contract value each year without incurring surrender charges. This penalty-free withdrawal amount is typically a percentage, often around 10% of the annuity’s value. Utilizing this feature can provide necessary liquidity while preserving the remaining annuity value and its tax-deferred growth.

Another option for individuals seeking a regular income stream is to annuitize the contract. Annuitization converts the annuity’s accumulated value into a series of periodic payments, which can be structured to last for a set period or for the remainder of the annuitant’s life. For those looking to transfer their annuity to a different contract or insurer, a 1035 exchange allows for a tax-free transfer of funds from one annuity to another, or even to a life insurance policy. While this avoids immediate taxation on gains, new surrender charge periods and fees typically apply to the new contract.

Initiating an Annuity Surrender

Should an individual decide to proceed with surrendering an annuity, the process involves a series of procedural steps. The initial action is to contact the annuity provider directly or consult with a financial advisor who assisted with the original purchase. The provider will then typically furnish the necessary surrender forms and provide specific instructions tailored to the individual’s contract.

It is important to complete these forms accurately, providing all requested personal and contract information. Along with the completed forms, the annuity provider may require additional documentation, such as proof of identity or a recent statement. Once all required paperwork is submitted, the insurance company will process the surrender, which can take a period of time to finalize. After processing, the funds, minus any applicable surrender charges and taxes, will be disbursed, and the individual will receive confirmation of the surrender and the receipt of funds.