Can You Take Out Your Annuity Early?

Annuities serve as financial tools designed for long-term savings and providing a steady income stream during retirement. Many individuals choose these contracts with insurance companies to secure their financial future. A common question arises, however, when circumstances change and there is a need to access these funds before their intended maturity.

Understanding Annuity Basics

An annuity is a contractual agreement between an individual and an insurance company. The individual makes payments, either as a lump sum or periodically, and in return, the insurer promises future income payments, often for a specified period or for life. Annuities are designed for long-term financial planning, especially for retirement income.

Annuities come in various forms, including fixed, variable, and indexed annuities, each offering different growth potential and risk profiles. Most annuities include a “surrender period,” a timeframe from three to 15 years, during which early withdrawals incur penalties from the insurance company. This period allows the insurer to recoup initial costs and manage invested funds, supporting the annuity’s design as a retirement vehicle.

Financial Consequences of Early Withdrawal

Accessing annuity funds before the surrender period ends or before reaching a certain age can lead to significant financial repercussions. These consequences involve fees imposed by the insurance company and taxes levied by the government.

A surrender charge is a fee assessed by the insurance company for withdrawals exceeding a contract’s allowance during the surrender period. These charges are calculated as a percentage of the amount withdrawn, starting high, such as 7% to 10% in the first year, and gradually declining over the surrender period until they reach zero. For instance, a contract might impose a 7% charge in year one, decreasing by one percentage point each subsequent year.

Beyond insurer-imposed fees, early withdrawals also trigger tax implications. Earnings withdrawn from non-qualified annuities, purchased with after-tax dollars, are taxed as ordinary income, not at lower capital gains rates. The Internal Revenue Service (IRS) applies a “Last-In, First-Out” (LIFO) rule, meaning earnings are considered withdrawn first, making initial withdrawals fully taxable. For qualified annuities, such as those held within an IRA or 401(k), the entire withdrawal, including both contributions and earnings, is subject to ordinary income tax, as these funds were contributed on a pre-tax basis.

The IRS 10% early withdrawal penalty is another financial consequence. This federal income tax penalty, under Internal Revenue Code Section 72, applies to the taxable portion of withdrawals made before the annuity owner reaches age 59½. This penalty is in addition to the ordinary income tax due on the withdrawn amount. For non-qualified annuities, this penalty applies only to the earnings portion, while for qualified annuities, it applies to the entire taxable amount withdrawn. Early withdrawals also reduce the annuity’s principal, diminishing its future growth potential and eventual income payments during retirement.

Situations Allowing Penalty-Free Access

While early withdrawals come with financial penalties, certain circumstances and contract provisions may allow access to annuity funds without incurring all or some of these standard charges. One way to avoid penalties is through annuitization, which involves converting the annuity’s accumulated value into a stream of regular income payments. Payments received through annuitization are not subject to the 10% IRS early withdrawal penalty or surrender charges. Similarly, if the annuitant dies, death benefits paid to beneficiaries bypass the 10% IRS early withdrawal penalty, though income tax on the earnings portion may still apply.

Total and permanent disability of the annuitant provides another exception. Many annuity contracts and IRS regulations, including Internal Revenue Code Section 72, waive the 10% early withdrawal penalty in cases where the annuitant becomes totally and permanently disabled. The Substantially Equal Periodic Payments (SEPPs) rule, outlined in IRS Section 72, also permits penalty-free withdrawals before age 59½. This is provided payments are taken in a series of substantially equal amounts over the annuitant’s life expectancy. These payments must adhere to strict IRS guidelines, and any modification to the payment schedule before certain conditions are met can result in retroactive penalties.

Many annuity contracts also include specific riders or waivers that can provide penalty-free access under defined conditions. For example, a terminal illness waiver may allow withdrawals without surrender charges if a physician certifies that the annuitant has a limited life expectancy, 12 months or less. Similarly, long-term care riders permit withdrawals for qualified long-term care expenses, such as nursing home care, when the annuitant is unable to perform a certain number of daily living activities. Some contracts also feature a nursing home waiver, which waives surrender charges if the annuitant is confined to a nursing home for a specified period, such as 90 consecutive days. Additionally, many annuities offer a “free withdrawal provision,” allowing policyholders to withdraw a certain percentage, 5% to 10% of the contract value, annually without incurring surrender charges from the insurer, although income tax and the 10% IRS penalty may still apply if the annuitant is under 59½.

Process for Requesting a Withdrawal

When an annuity owner decides to request a withdrawal, the first step involves directly contacting the insurance company that issued the annuity contract. This initial communication will provide clarity on the specific procedures and requirements for your particular contract.

Thoroughly review your specific annuity contract for precise terms, any applicable surrender schedules, and details of any riders or provisions that might apply. The provider will supply the necessary withdrawal request forms that must be completed. These forms will require personal details, the annuity contract number, and the exact amount or method of withdrawal desired.

Once the forms are completed, they can be submitted through various methods, such as mail, fax, or an online portal provided by the insurance company. Processing times can vary, but the provider can offer an idea of how long it will take for the funds to be disbursed, which might be by check or electronic transfer. Before making a final decision to withdraw funds, consulting with a financial advisor or tax professional is recommended to understand all potential implications for your personal financial situation.