What Is the Penalty for Cashing Out an Annuity?

Cashing out an annuity can have significant financial consequences, particularly if done before retirement. While it provides immediate access to funds, tax liabilities and penalties can reduce the payout. Understanding these implications is crucial before making a decision.

Several factors must be considered when withdrawing from an annuity, including taxes, early withdrawal fees, and possible alternatives. Making an informed choice helps avoid unnecessary losses and protects long-term financial stability.

Definition of Annuity Cash-Out

An annuity cash-out refers to withdrawing funds from an annuity contract, either partially or in full, before the scheduled payout period. Annuities are designed to provide a steady income stream, often for retirement, but some policyholders access their money earlier due to financial needs or changing circumstances. The method of cashing out depends on the type of annuity, contract terms, and financial institution.

There are multiple ways to cash out an annuity, each with different consequences. A full surrender withdraws the entire balance, terminating the contract. A partial withdrawal allows access to some funds while keeping the annuity active. Some contracts offer structured withdrawals, where funds are accessed in scheduled increments rather than as a lump sum. These options often come with restrictions on withdrawal amounts and timing.

Tax Implications of Cashing Out

Withdrawing money from an annuity has tax consequences that affect the final amount received. The tax treatment depends on whether the annuity was funded with pre-tax or after-tax dollars. If purchased with pre-tax funds, such as through a traditional IRA or 401(k) rollover, the entire withdrawal is taxed as ordinary income. Annuities do not qualify for lower capital gains tax rates, meaning withdrawals are subject to federal and state income taxes at the individual’s marginal tax rate, which can be as high as 37% in 2024 for high earners.

For annuities funded with after-tax dollars, only the earnings portion of the withdrawal is taxable. The IRS applies an exclusion ratio to determine what percentage of each payout is considered a return of principal versus taxable income. If the cash-out occurs before annuity payments begin, the earnings are taxed first under the last-in, first-out (LIFO) rule, meaning all taxable gains must be withdrawn before accessing the principal.

Financial institutions often withhold 10% to 20% of the withdrawal amount for federal taxes, though this may not cover the full tax liability. Depending on the state of residence, additional state taxes may also be withheld. If the withholding is insufficient, the policyholder may owe more when filing their tax return, potentially leading to underpayment penalties.

Early Withdrawal Penalties

Taking money out of an annuity before a certain age can result in financial penalties. One of the most common is the surrender charge, imposed by the insurance company when an annuity is cashed out within the surrender period. This period typically lasts between six and ten years from the date of purchase. Surrender charges are highest in the first year, often around 7%, and decrease annually. For example, if an annuity has a 7% surrender charge in year one and declines by 1% each year, a withdrawal in year four would result in a 4% fee.

Beyond surrender charges, the IRS imposes a 10% early withdrawal penalty on annuity distributions taken before age 59½. This penalty applies to the taxable portion of the withdrawal, meaning any gains taken out before this age will be subject to both ordinary income tax and the additional 10% charge. Unlike surrender charges, which decrease over time, this IRS penalty remains fixed. For example, withdrawing $50,000 in taxable gains before turning 59½ would result in an extra $5,000 penalty on top of regular income taxes.

Some annuity contracts also include market value adjustments (MVAs), which can impact early withdrawals. MVAs compensate the insurer for changes in interest rates and can either increase or decrease the amount received. If interest rates have risen since the annuity was purchased, an MVA may reduce the payout, whereas if rates have fallen, the adjustment could result in a higher withdrawal amount. This feature is most common in fixed annuities and should be reviewed before making a decision.

Exceptions to Penalties

Certain situations allow annuity holders to access their funds without incurring early withdrawal penalties. One exemption applies to individuals who become permanently disabled. If a policyholder can provide medical evidence that they are unable to engage in substantial gainful activity due to a long-term physical or mental condition, the 10% early withdrawal penalty does not apply.

Another exemption exists for individuals who take substantially equal periodic payments (SEPPs) under IRS Section 72(t). This rule allows annuity holders to withdraw funds in a structured manner using one of three approved calculation methods: the required minimum distribution method, the fixed amortization method, or the fixed annuitization method. Once initiated, these payments must continue for at least five years or until the individual reaches age 59½, whichever is longer. If payments are modified before this period ends, retroactive penalties may apply.

If an annuity holder passes away, beneficiaries who inherit the annuity are typically exempt from early withdrawal penalties. Depending on the type of annuity and beneficiary designation, they may have several distribution options, including taking a lump sum, receiving payments over a five-year period, or using a life expectancy-based payout structure. While ordinary income taxes still apply to the taxable portion of the inherited annuity, the IRS does not impose the 10% penalty on distributions made due to the original owner’s death.

Impact on Retirement Planning

Cashing out an annuity early can disrupt long-term financial security, particularly for those relying on it as a primary source of retirement income. Annuities are structured to provide a steady stream of payments, ensuring financial stability later in life. When funds are withdrawn prematurely, the account balance shrinks, and future earnings potential is reduced. Since annuities grow on a tax-deferred basis, early withdrawals eliminate the benefits of compounding interest. For example, a $100,000 annuity growing at 5% annually would double in approximately 14 years if left untouched, but cashing out early forfeits this growth.

Withdrawing from an annuity can also affect other retirement assets. If the funds are used for short-term expenses, individuals may need to rely more heavily on Social Security, 401(k) plans, or other investment accounts in retirement. This shift can lead to increased tax liabilities and a higher risk of outliving savings. Additionally, annuities often serve as a hedge against market volatility, providing guaranteed income regardless of economic conditions. Without this protection, retirees may be more exposed to market downturns, potentially forcing them to sell other investments at a loss to cover expenses. Careful planning is necessary to ensure that accessing annuity funds does not compromise long-term financial goals.

Alternatives to Cashing Out

For those considering an annuity withdrawal, there are several alternatives that may provide financial relief without incurring penalties or tax burdens.

One option is taking a loan against the annuity, if permitted by the contract. Some annuities allow policyholders to borrow a portion of their account value without triggering taxes or penalties, as long as the loan is repaid according to the terms. However, failure to repay the loan may result in the outstanding balance being treated as a taxable distribution.

Another approach is utilizing the annuity’s free withdrawal provision. Many contracts allow policyholders to withdraw a small percentage—typically 10%—of the account value annually without incurring surrender charges. This strategy enables access to cash while keeping the annuity intact for future income needs.

Selling the annuity on the secondary market is another option for those who need a larger lump sum. Companies specializing in annuity buyouts offer cash in exchange for the rights to future payments. While this can provide immediate funds, the sale price is often lower than the annuity’s total value, as buyers discount future payments to account for risk and profit margins. Additionally, structured settlement annuities may require court approval before they can be sold.

Another alternative is converting the annuity into a different financial product, such as a lifetime income stream or a different type of annuity with more flexible withdrawal options. Some insurers offer annuity exchanges under Section 1035 of the tax code, allowing policyholders to transfer funds into a new annuity without triggering immediate tax consequences. This can be beneficial for those seeking better terms, lower fees, or improved liquidity options.