Should I Cash In My Annuity? Key Factors to Consider

Deciding whether to cash in an annuity is a significant financial assessment. Many individuals consider this option when faced with changing financial circumstances or unexpected needs. Understanding your specific annuity contract and the potential financial consequences is crucial before taking any action.

Understanding Your Annuity Contract

Reviewing your annuity contract is the starting point for understanding its terms. The type of annuity you own, such as fixed, variable, or indexed, influences its surrender provisions. Some annuities, like annuitized or immediate annuities, may not allow withdrawals. Your contract outlines these distinctions.

Locate the surrender charge schedule, which details fees for early withdrawals. These charges are typically calculated as a percentage of the amount withdrawn or the contract value. The percentage usually declines over time, often starting around 7% to 10% in the initial years and decreasing by one percentage point annually. This period, known as the surrender period, commonly ranges from three to ten years.

Many annuity contracts include free withdrawal provisions, allowing you to withdraw a certain percentage of your account value each year without incurring surrender charges. This allowance is frequently around 10% of the contract value. Identifying these limits is important for accessing funds without penalty. Also, examine any attached riders, such as guaranteed income benefits or enhanced death benefits, as cashing out your annuity may result in their forfeiture.

Financial Implications of Surrendering Your Annuity

Fully surrendering an annuity triggers financial consequences, starting with surrender charges imposed by the insurance company. These charges discourage early withdrawals and help the insurer recover upfront costs, including commissions. The fees can significantly reduce the amount you receive, often ranging from 7% to 10% of the withdrawn amount in the early years. This reduction occurs because the surrender value is calculated by subtracting these charges from your contract’s accumulated value.

Any gains realized from your annuity are taxed as ordinary income, not capital gains. For non-qualified annuities, funded with after-tax dollars, the IRS applies a “Last-In, First-Out” (LIFO) rule for withdrawals. This means earnings are considered withdrawn first and are fully taxable until all gains are exhausted. Once all earnings have been withdrawn, the return of your original premiums, or “cost basis,” becomes tax-free.

An additional 10% early withdrawal penalty applies to the taxable portion of withdrawals made before age 59½. This penalty is separate from and in addition to any ordinary income taxes owed. Several exceptions exist, including withdrawals due to death, disability, or if payments are part of a series of substantially equal periodic payments. Other exceptions include certain medical expenses or annuitization of the contract.

Cashing out an annuity results in the loss of its tax-deferred growth benefits. Earnings within an annuity grow without being taxed until withdrawn, a feature that ends upon surrender. Any guarantees provided by the contract, such as a guaranteed income stream for life or a death benefit for beneficiaries, are forfeited. These features are inherent to the annuity’s design and cannot be retained once the contract is fully surrendered.

Exploring Other Options

Instead of a full surrender, individuals can opt for partial withdrawals from their annuity. Many contracts allow you to withdraw up to a certain percentage, commonly 10% of the account value annually, without incurring surrender charges. The remaining balance continues to grow on a tax-deferred basis, maintaining its long-term accumulation potential. These partial withdrawals from non-qualified annuities are taxed under the LIFO rule, meaning gains are withdrawn and taxed first.

A 1035 exchange permits a tax-free transfer of funds from one annuity contract to another, or even to a life insurance policy. While this allows for potential adjustments to contract features or fees, a new surrender charge period begins with the new contract. This means you could be subject to new fees or different benefit structures in the replacement policy. Careful consideration of the new contract’s terms is necessary before initiating such an exchange.

Annuitization converts the annuity’s accumulated value into a predictable stream of regular income payments. These payments can be structured to last for a set period, such as 10 or 20 years, or for the remainder of your life. Various annuitization options exist, including single life, joint life, or period certain payouts. Each payment received is comprised of both a taxable portion, representing earnings, and a tax-free portion, representing a return of your original principal.

Some annuities, particularly variable annuities, may offer policy loans. This allows you to access funds without fully surrendering the contract or immediately triggering taxation, provided the loan is repaid. If the loan is not repaid, the outstanding amount may be treated as a taxable distribution and could be subject to income tax and potential early withdrawal penalties. Annuity loans are available for deferred annuities in their accumulation phase.

Key Considerations for Your Decision

Evaluating your current financial needs and liquidity is important for considering cashing out an annuity. Determine if your need for funds is immediate, and explore whether other, less costly sources of liquidity are available. Accessing funds from an annuity prematurely might incur significant costs that could be avoided by utilizing other assets.

Consider how cashing out your annuity will impact your long-term financial goals, especially retirement and legacy planning. Annuities are designed to provide a steady income stream, often for retirement. Forfeiting this guaranteed income source can alter your financial security in later years and affect what you leave to your beneficiaries.

Assess your investment horizon and risk tolerance if you plan to reinvest the surrendered funds. Consider whether the new investments align with your comfort level for risk and your timeline for needing the money. The decision should reflect your overall investment strategy and financial objectives.

The current interest rate environment and market outlook can also influence your decision. In periods of higher interest rates, new annuities may offer more attractive payout rates, potentially making a surrender and reinvestment appealing. Some annuities include market value adjustments (MVAs) which can adjust your payout up or down based on changes in interest rates since your purchase.

Given the complexities involved, consulting with a qualified financial advisor and a tax professional is recommended. These professionals can provide personalized guidance regarding your specific contract terms, tax implications, and alternative strategies. Their expertise can help you make an informed decision that aligns with your unique financial situation and long-term goals.