What Happens If You Cash Out an Annuity?

An annuity is a contract between an individual and an insurance company, designed primarily to provide a steady stream of income, often during retirement. It involves an initial payment or series of payments made to the insurer, which then grows tax-deferred over time. While annuities are typically intended for long-term financial planning and income distribution, circumstances may arise where an individual considers accessing the funds before the contract’s maturity.

Understanding Annuity Surrender

Cashing out an annuity is commonly referred to as surrendering the contract. This means the contract holder requests to withdraw the entire accumulated value from the insurance company. This action typically occurs before income payments begin or before the end of a specified surrender period.

Annuity contracts often include a surrender period, typically six to ten years, during which penalties apply if the contract is fully or partially surrendered. This period allows the insurance company to recoup expenses and encourages long-term commitment. The length and charges are outlined in the contract.

Surrender charges are fees imposed by the insurance company for early withdrawals or full surrender within the surrender period. These charges are typically a declining percentage of the amount withdrawn or the contract’s value. For instance, a common schedule might start at 7% or 8% in the first year and decrease by one percentage point each subsequent year until the charge becomes zero. This charge directly reduces the amount an individual receives upon cashing out.

Tax Consequences of Early Withdrawal

Withdrawing funds from an annuity, particularly before the age of 59½, can trigger significant tax implications. The earnings portion of an annuity withdrawal is generally taxed as ordinary income, not at potentially lower capital gains rates. This means that any growth within the annuity is subject to the individual’s regular income tax bracket, which can be substantial depending on the amount withdrawn and the individual’s other income sources.

For withdrawals made before the annuity owner reaches age 59½, an additional 10% federal income tax penalty typically applies to the taxable portion. This penalty, outlined in Internal Revenue Code Section 72, discourages using annuities for short-term savings. Specific exceptions to this 10% additional tax include distributions due to the owner’s death or total and permanent disability.

Another exception to the 10% additional tax is if distributions are part of a series of substantially equal periodic payments (SEPP). These payments must be made at least annually over the life expectancy of the annuity owner or joint life expectancies. Once initiated, payments must generally continue for at least five years or until the owner reaches age 59½, whichever is later. Failure to adhere to SEPP requirements can result in retroactive application of the 10% penalty.

The order in which funds are considered withdrawn for tax purposes depends on the annuity’s qualification status. For non-qualified annuities, purchased with after-tax dollars, the Last-In, First-Out (LIFO) rule generally applies. Earnings are withdrawn first and are fully taxable as ordinary income, before the tax-free return of principal. For qualified annuities, such as those in a 401(k) or IRA, withdrawals are typically taxed on a pro-rata basis, meaning each payment consists of both taxable earnings and non-taxable principal, or the entire distribution is taxable if all contributions were pre-tax.

Calculating Your Net Proceeds

Calculating the net amount received when cashing out an annuity involves a multi-step process. It accounts for the initial investment, accumulated earnings, surrender charges, and tax implications. The process begins with the annuity’s current accumulated value, which includes principal contributions and investment growth. This represents the gross amount before deductions.

From this gross accumulated value, the first deduction is any surrender charge. This charge is a percentage of the amount withdrawn and varies based on how long the annuity has been held within its surrender period. For example, if an annuity with a $100,000 accumulated value is surrendered in its third year with a 5% surrender charge, $5,000 would be deducted, leaving a pre-tax amount of $95,000.

Next, identify the taxable portion of the withdrawal. For non-qualified annuities, this is typically the accumulated earnings, as per the LIFO rule. If the initial investment was $80,000 and the accumulated value is $100,000, the earnings are $20,000. After the surrender charge, the remaining $95,000 would still contain the entire $20,000 in earnings, which remains fully taxable, as the principal is withdrawn last.

Finally, applicable income taxes and, if relevant, the 10% early withdrawal penalty are applied to the taxable portion. This combined tax liability further reduces the amount received. Net proceeds are the original accumulated value minus surrender charges, and then minus the calculated tax liability on the taxable portion.

Other Options for Accessing Annuity Funds

Instead of fully surrendering an annuity, several alternative strategies exist for accessing funds. One common option is to make partial withdrawals. This allows the owner to take out a portion of the annuity’s value while leaving the remainder invested. Partial withdrawals may still be subject to pro-rata surrender charges or trigger the LIFO tax rule for non-qualified annuities, but they provide liquidity without incurring full surrender penalties.

Another approach is annuitization, which converts the annuity’s accumulated value into a guaranteed stream of income payments over a specified period or for the annuitant’s lifetime. This fulfills the primary purpose of an annuity by providing regular, predictable income. Once annuitized, the ability to take lump-sum withdrawals is generally forfeited, as the contract transitions from an accumulation to a distribution phase.

A 1035 exchange offers a tax-free way to transfer funds from one annuity contract to another, or to a long-term care insurance policy. This exchange is permitted under Internal Revenue Code Section 1035 and allows individuals to move funds to a different annuity product that may offer better features, lower fees, or more suitable investment options. The original cost basis and tax-deferred status are preserved in the new contract.