What Happens If You Don’t Annuitize an Annuity?

An annuity is a contract between an individual and an insurance company, where the individual pays a sum of money in exchange for regular payments, either immediately or in the future. Annuitization converts the accumulated value of an annuity into a series of periodic income payments, which can last for a set period or for the rest of one’s life. However, an annuity owner is not always required to annuitize their contract. This article explores the outcomes and options available if an annuity owner chooses not to annuitize.

Alternatives to Annuitization

If an annuity owner decides against annuitizing their contract, several alternatives allow them to access or continue growing their funds.

Lump-Sum Withdrawal

One common alternative is a lump-sum withdrawal, where the annuity owner takes the entire accumulated value of the contract at once. This provides immediate access to the full sum of money. However, taking a lump sum can have significant tax consequences, as all the untaxed earnings become immediately taxable.

Systematic Withdrawals

Another option involves systematic withdrawals, which entail planned, regular withdrawals of a chosen amount over a period. The remaining funds continue to grow within the annuity. This approach offers flexibility, allowing the owner to control the withdrawal amount and frequency.

Continued Accumulation

An annuity owner may also choose to leave funds in the accumulation phase, allowing the money to remain invested within the annuity. In this scenario, the funds continue to grow on a tax-deferred basis. This can be beneficial for individuals who do not need immediate income and wish to maximize the tax-deferred growth potential.

Financial and Tax Implications

Choosing not to annuitize an annuity carries financial and tax implications depending on the chosen alternative.

Taxation of Withdrawals

Withdrawals from an annuity are generally subject to taxation on the earnings portion as ordinary income. For non-qualified annuities, funded with after-tax dollars, only the growth is taxed upon withdrawal, following a “Last-In, First-Out” (LIFO) accounting method. For qualified annuities, typically funded with pre-tax dollars, the entire amount of the withdrawal is usually taxed as ordinary income.

Early Withdrawal Penalties

A federal penalty of 10% may apply to the taxable portion of withdrawals made before the annuity owner reaches age 59½. This penalty is in addition to regular income taxes and is designed to discourage early access to retirement savings.

Surrender Charges

Annuity contracts often include surrender charges, which are fees imposed by the insurance company for withdrawals exceeding a certain percentage or for full surrender of the contract during an initial period. This surrender charge period typically lasts between 6 to 10 years, with the fee decreasing each year. Many contracts permit penalty-free withdrawals of a small percentage, often up to 10% of the contract value, annually.

Tax-Deferred Growth

If funds are left in the accumulation phase, tax-deferred growth continues, meaning earnings are not taxed until they are withdrawn. This strategy delays taxation, potentially allowing for greater long-term growth, but does not eliminate the tax liability on earnings.

Implications for Beneficiaries

When an annuity has not been annuitized, its accumulated value typically becomes part of the owner’s estate upon their death and is paid out to designated beneficiaries. The manner in which beneficiaries receive these funds, and the associated tax implications, can vary significantly.

Beneficiary Payout Options

Beneficiaries generally have several options for receiving the death benefit. These options commonly include taking a lump-sum payment, opting for systematic withdrawals over a period, or, in some cases, utilizing “stretch” options. A lump-sum payout provides immediate access to the funds but can result in a substantial tax bill in the year of receipt, potentially pushing the beneficiary into a higher tax bracket.

Alternatively, beneficiaries can choose to receive payments over a period, often five years, or, for certain eligible beneficiaries, over their life expectancy. This approach can help spread out the tax burden over multiple years. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 significantly changed these rules for most non-spouse beneficiaries of inherited retirement accounts, generally requiring the entire balance to be distributed within 10 years following the owner’s death, unless they qualify as an “eligible designated beneficiary” (e.g., spouse, minor child, disabled or chronically ill individual, or someone not more than 10 years younger than the original owner).

Taxation for Beneficiaries

Regardless of the payout method, the untaxed gains within the annuity are generally taxable to the beneficiary as ordinary income. For qualified annuities, the entire distribution is typically taxable because the original contributions were pre-tax. For non-qualified annuities, only the earnings are taxed, as the principal was contributed with after-tax dollars.

Reviewing Your Annuity Contract

Understanding the specific terms and conditions of an individual annuity contract is paramount, as these documents dictate the available options and their consequences. Each annuity contract is unique, and its provisions can significantly impact decisions regarding non-annuitization.

Maturity Date and Default Provisions

Annuity contracts often specify a “maturity date,” which is the point in time when the contract is designed to begin its income phase. This date is typically set at a certain age, such as 85 or 90, or after a predetermined number of years. If an owner does not make an annuitization choice by this date, the contract may default to a specific outcome, such as continued accumulation, or the initiation of systematic withdrawals.

Importance of Review

It is important to review the contract documents carefully to identify the maturity date, any default provisions, and the specific options available for accessing funds or continuing tax-deferred growth. Contacting the annuity provider directly can also clarify any unique provisions, deadlines, or potential fees related to not annuitizing the contract. This proactive review ensures that the annuity owner can make informed decisions aligned with their financial goals and avoid unintended outcomes.