How to Get Out of an Annuity and What to Expect
Navigate how to exit your annuity. Understand the process, explore various methods, and learn what to expect when terminating your contract.
Navigate how to exit your annuity. Understand the process, explore various methods, and learn what to expect when terminating your contract.
An annuity is a contract between an individual and an insurance company, often used for retirement savings or to provide a steady income stream. While annuities are long-term financial commitments, circumstances can lead individuals to terminate contracts prematurely. Understanding how to exit an annuity and the associated financial implications is important for informed decision-making. This article explores annuity termination and the different methods available to contract holders.
Terminating an annuity involves several financial considerations, including surrender charges, market value adjustments, tax implications, and the forfeiture of potential future benefits. These elements reduce the amount an annuity owner receives upon early termination. Each annuity contract outlines specific terms and conditions regarding withdrawals and surrenders.
Surrender charges are fees imposed by the insurance company if funds are withdrawn or the contract is canceled before a specified period ends. This “surrender period” ranges from three to ten years, with charges often starting high (e.g., 7% to 10% in the first year) and gradually declining. Many annuity contracts include a “free withdrawal” provision, allowing policyholders to withdraw a certain percentage of their contract value, commonly 10%, annually without incurring these charges. Exceeding this allowance, or surrendering the entire contract, will trigger the applicable surrender charge.
Beyond surrender charges, a Market Value Adjustment (MVA) may apply to certain annuities, particularly fixed or fixed-indexed annuities, upon early withdrawal or surrender. An MVA is a contractual adjustment reflecting changes in interest rates since the annuity was issued. If market interest rates have risen, the MVA will likely reduce the surrender value; a decline in rates could result in a positive adjustment. This adjustment helps the insurance company align the surrender value with current market conditions and manage interest rate risk.
Tax implications are a significant aspect of annuity termination, as earnings grow on a tax-deferred basis until distribution. When withdrawals or lump-sum surrenders occur, the earnings portion is taxed as ordinary income. For non-qualified annuities, funded with after-tax dollars, only investment gains are taxable, with original contributions returned tax-free. For qualified annuities, often held within retirement plans like 401(k)s or IRAs, the entire distribution is taxed as ordinary income because it was funded with pre-tax dollars.
An additional 10% federal income tax penalty applies to the taxable portion of distributions taken before age 59½. This penalty is imposed unless a specific exception applies, such as distributions due to the annuitant’s death or total and permanent disability. Other exceptions include distributions received as part of a series of substantially equal periodic payments (SEPP) or those from certain qualified retirement plans after separation from service at age 55 or older. Understanding these tax rules and potential penalties is important to accurately assess the net amount received from an early annuity termination.
Terminating an annuity means forfeiting any future guaranteed income streams, riders, or death benefits associated with the contract. Many annuities are purchased for their promise of lifetime income or specific guarantees, such as guaranteed living benefits or enhanced death benefits. By surrendering the contract, these valuable features are lost, and the contract holder will no longer receive scheduled payments or be eligible for rider benefits. This forfeiture should be weighed against the immediate need for funds or the benefits of moving to a different financial product.
Several distinct methods allow individuals to exit an annuity contract, each with its own procedural steps and implications. The choice of method depends on the individual’s financial needs, the specific terms of their annuity contract, and their long-term financial goals. Financial consequences like surrender charges and tax implications apply broadly, but their specific impact varies by method.
A full surrender involves completely canceling the annuity contract and receiving the remaining cash value as a lump sum. To initiate a full surrender, the annuity owner contacts the issuing insurance company or financial advisor to request paperwork. This includes a surrender request form, which must be completed accurately and may require a signature guarantee or notarization.
The insurance company reviews the request and calculates the surrender value, subtracting any applicable surrender charges and outstanding fees. Receiving funds generally takes seven to fourteen business days after the insurer receives all required documents. The distributed amount will be subject to ordinary income taxes on any gains, and if the owner is under age 59½, a 10% federal tax penalty may also apply.
Instead of a full surrender, an annuity owner can opt for a partial withdrawal, taking out a portion of the contract’s value while keeping the remainder invested. Most annuity contracts allow penalty-free partial withdrawals of a certain percentage of the account value annually, commonly 10%, without incurring surrender charges. Amounts withdrawn in excess of this allowance will be subject to surrender charges.
To request a partial withdrawal, the annuity owner submits a partial withdrawal request form to the insurance company, specifying the desired amount. This process helps maintain the annuity contract and its remaining benefits, though the contract value and future income potential will be reduced. The taxable portion of any partial withdrawal, representing earnings, will be subject to ordinary income taxes, and the 10% early withdrawal penalty may apply if the owner is under age 59½.
Annuitization is the process of converting the annuity’s accumulated value into a stream of guaranteed periodic payments, transitioning from the accumulation phase to the payout phase. This method does not involve cashing out the annuity in a lump sum but transforms it into a predictable income stream. Annuity owners can choose various annuitization options: payments for a specified period (period certain), for their lifetime (life only), or for the lifetimes of both themselves and a beneficiary (joint and survivor).
To annuitize, the owner submits an annuitization election form to the insurance company, selecting the desired payment option and frequency. The amount of each payment is determined by the annuity’s value, the annuitant’s age, and the chosen payout option. A portion of each annuitized payment is considered a tax-free return of the original premium, while the remainder is taxed as ordinary income, determined by an exclusion ratio.
A 1035 exchange allows for the tax-free transfer of funds from one annuity contract to another, or to certain other insurance products like long-term care insurance, without incurring immediate taxes on accumulated gains. This provision, outlined in Section 1035 of the Internal Revenue Code, facilitates moving funds to a new contract that may offer better features, lower fees, or higher interest rates. For an exchange to qualify as tax-free, the transfer must be made directly between insurance companies, and the policyholder must remain the same.
The new annuity contract will come with a new surrender charge schedule, meaning the policyholder will face new surrender penalties if they withdraw funds prematurely. While the 1035 exchange avoids current taxation, it does not bypass potential future surrender charges or the 10% federal tax penalty if withdrawals are made before age 59½ from the new contract. The process involves coordinating with both the existing and new insurance carriers to ensure a direct transfer of funds.
An annuity owner can sell future annuity payments to a third-party company in the annuity secondary market. This option provides a lump sum of cash in exchange for some or all future payments. The third-party company, often called a factoring company, purchases these payments at a discount, reflecting the time value of money, administrative costs, and their profit margin.
The process involves contacting several factoring companies for quotes, reviewing terms, and completing paperwork. For annuities from structured settlements, such as personal injury awards, court approval is often required to ensure the sale is in the seller’s best interest. The tax implications of selling an annuity on the secondary market can be complex, and the lump sum received is subject to ordinary income tax. It is advisable to consult with a tax professional to understand the specific tax treatment and potential impact.