How to Avoid a Surrender Charge on Your Policy

A surrender charge is a penalty fee assessed when funds are withdrawn from an insurance or annuity contract prematurely, or when the contract is canceled before a specified period. These charges allow insurance companies to recover initial expenses, such as sales commissions and administrative costs. This fee also encourages policyholders to commit to the long-term nature of these financial products, discouraging their use for short-term liquidity needs. Surrender charges are common in deferred annuities and certain life insurance policies, including whole life, universal life, indexed universal life (IUL), and variable universal life (VUL) insurance. For these products, charges apply for a predetermined number of years, known as the surrender period.

Decoding Your Policy’s Surrender Schedule

Understanding your policy’s surrender schedule is the first step in avoiding unexpected charges. This schedule outlines the duration for which charges apply and the percentage levied on early withdrawals or cancellations. You can find this information in sections of your policy contract labeled “Surrender Charges” or “Withdrawal Provisions.”

A surrender schedule defines a period, often 7 to 10 years, during which charges are active. The charge percentage usually starts higher in initial years, such as 7% to 10% in the first year, then progressively declines by approximately one percentage point each subsequent year until it reaches zero. For example, a policy might impose a 7% charge in year one, 6% in year two, and so on, until the charge is eliminated after the surrender period concludes.

Many policies include a “free withdrawal allowance,” permitting you to withdraw a certain percentage of your account value annually without incurring a surrender charge. This allowance commonly ranges from 5% to 10% of the policy’s accumulated cash value or the prior year’s contract value. For instance, if your policy has a 10% free withdrawal allowance and a $100,000 value, you could withdraw up to $10,000 in a year without a charge. When a withdrawal exceeds this free allowance, the surrender charge is applied only to the amount that surpasses the permitted limit. If you withdraw the entire policy value before the surrender period ends, the charge is applied to the total amount.

Leveraging Built-in Policy Features

Several built-in features can be leveraged to avoid or minimize charges. One common strategy is to utilize the free withdrawal allowance offered by your policy. This feature allows for partial, penalty-free access to funds, typically up to 10% of the account value each year.

Another approach to avoiding surrender charges is waiting until the surrender period expires. Once this predetermined period, usually between 7 and 10 years, has passed, the surrender charges are typically waived, allowing full access to your funds without penalty.

Many policies also offer specific waivers that can exempt you from surrender charges under certain circumstances. Common waivers include:
Death of the annuitant or insured, where beneficiaries receive the full policy value without charges.
Terminal illness, allowing penalty-free withdrawals if diagnosed with a life-limiting condition, provided medical criteria are met.
Disability, permitting access to funds without surrender charges if the policyholder becomes disabled and meets the policy’s definition, often after a waiting period.
Long-term care rider, which waives surrender charges if funds are used for qualified long-term care expenses.

For annuities, converting the accumulated cash value into a guaranteed stream of income, known as annuitization, often bypasses surrender charges. Even within the surrender period, electing to annuitize your contract usually allows you to receive payments without incurring the early withdrawal penalty.

Strategic Policy Transfers

A strategic approach to managing surrender charges involves transferring funds from one policy to another using a Section 1035 exchange. This provision of the Internal Revenue Code permits the tax-free transfer of cash value from an existing annuity or life insurance policy to a new, similar policy. This maneuver allows policyholders to avoid current income tax on gains and bypass the surrender charge on the original policy.

A 1035 exchange is often considered when a policyholder seeks a new policy with better features, lower internal fees, or different investment options without immediately triggering a taxable event or the surrender charge on their existing contract. The transfer typically involves the direct movement of funds between the two insurance companies, ensuring the transaction qualifies for tax-deferred status under IRS regulations.

While a 1035 exchange successfully avoids the surrender charge of the old policy, it usually initiates a new surrender period with the new policy. This means your funds will likely be subject to new surrender charges if withdrawn prematurely from the replacement policy. The new surrender period can range from 7 to 10 years, effectively resetting the clock on liquidity restrictions.

Before undertaking a 1035 exchange, evaluate the terms of the new policy, including its surrender schedule, fees, and overall benefits, to ensure it aligns with your long-term financial objectives.