When Can You Withdraw From an Annuity?

An annuity is a financial contract issued by an insurance company, designed primarily to provide a steady income stream, often for retirement. It functions as a tool to help individuals accumulate funds on a tax-deferred basis and then convert those savings into regular payments, addressing the concern of outliving one’s assets.

Understanding Annuity Withdrawal Options

Accessing annuity funds can occur through various methods, each with distinct implications. A common approach is a partial withdrawal, where a portion of the annuity’s value is taken out while the contract remains in force. Many annuity contracts allow up to 10% of the account value to be withdrawn annually without incurring surrender charges. This “free withdrawal” provision offers liquidity, but exceeding this limit results in additional fees.

Another option is a full surrender, also known as a lump sum withdrawal, where the entire contract is cashed out, terminating the annuity. This provides immediate access to the accumulated value but closes the contract, ending future benefits or guarantees. A full surrender may be subject to surrender charges and potential tax implications depending on the annuitant’s age and contract type.

Annuitization converts the annuity’s accumulated value into a series of regular, guaranteed payments. This can be structured to pay out for a fixed period or for the annuitant’s life, or even the joint lives of the annuitant and a beneficiary. Immediate annuitization begins payments within a year of purchase, while deferred annuitization allows for accumulation before payments begin. Once annuitized, the decision is irrevocable, and the contract value is no longer accessible as a lump sum.

Common Restrictions on Withdrawals

Annuity withdrawals are subject to specific limitations and conditions that impact the amount received and timing of access. A primary restriction involves surrender periods and their associated charges. A surrender period is a pre-set number of years, commonly three to ten years, during which a fee is assessed if withdrawals exceed the contract’s free withdrawal allowance. This charge, often starting around 7% and decreasing annually, compensates the insurer for issuing the annuity and managing investments.

Federal tax rules impose restrictions, notably the age-based rule for withdrawals before age 59½. The Internal Revenue Service (IRS) assesses an additional 10% tax penalty on the taxable portion of distributions from qualified retirement plans and non-qualified annuity contracts made before this age. This penalty is separate from any surrender charges imposed by the insurer.

Individual annuity contracts include specific limitations, such as minimum withdrawal amounts or restrictions on withdrawal frequency. For instance, some annuities, particularly those for immediate income, may not allow cash withdrawals of the contract value. Reviewing the terms of an annuity contract is important to understand these provisions.

Certain annuities, particularly fixed-indexed annuities, may incorporate a Market Value Adjustment (MVA). An MVA can increase or decrease the withdrawal amount based on changes in interest rates between purchase and withdrawal. If interest rates are higher at withdrawal than at purchase, the MVA reduces the payout, while lower rates can result in an increase. This adjustment applies only to withdrawals exceeding the free withdrawal allowance and during the surrender charge period.

Taxation of Annuity Withdrawals

The tax implications of annuity withdrawals vary depending on how the annuity was funded and distribution timing. For non-qualified annuities, purchased with after-tax dollars, only the earnings portion of a withdrawal is subject to ordinary income tax. The IRS applies the “Last-In, First-Out” (LIFO) rule to these withdrawals, meaning earnings are withdrawn first and taxed before any original, tax-free principal is returned. Once all earnings have been withdrawn, subsequent distributions of the principal are tax-exempt.

When a non-qualified annuity is annuitized and begins paying a series of regular payments, an “exclusion ratio” determines the taxable and non-taxable portions of each payment. A portion of each payment is considered a return of the original principal (which is tax-free), and the remaining portion is treated as taxable earnings. This ratio ensures the principal is returned tax-free over the expected payout period.

In contrast, withdrawals from qualified annuities, such as those held within a 401(k) or IRA, are fully taxable as ordinary income. This is because these annuities are funded with pre-tax contributions, meaning neither contributions nor their growth have been taxed. Consequently, every dollar withdrawn from a qualified annuity is subject to income tax.

In addition to ordinary income taxes, withdrawals made before age 59½ are subject to an additional 10% federal tax penalty on the taxable portion. This penalty is imposed by the IRS to discourage early access to funds intended for retirement. Insurers may also be required to withhold a portion of annuity payments for tax purposes.

Exceptions to Early Withdrawal Penalties

While withdrawals from annuities before age 59½ incur an additional 10% federal tax penalty, several exceptions allow access to funds without this penalty. One common exception applies to distributions made to a beneficiary upon the annuitant’s death. This allows inherited funds to be accessed without the early withdrawal penalty, though income tax on earnings may still apply.

Another exception is for annuitants who become totally and permanently disabled. If a physician certifies the individual cannot engage in substantial gainful activity due to a physical or mental condition expected to result in death or be of indefinite duration, the 10% penalty may be waived. This provision provides financial flexibility during unforeseen circumstances.

The penalty can be avoided through Substantially Equal Periodic Payments (SEPPs), often referred to as 72(t) payments. This involves taking a series of regular, fixed payments over the annuitant’s life expectancy or the joint life expectancies of the annuitant and a beneficiary. These payments must continue for at least five years or until the annuitant reaches age 59½, whichever period is longer.

Withdrawals for qualified higher education expenses for the annuitant, spouse, children, or grandchildren can be exempt from the 10% penalty. Similarly, funds used for unreimbursed medical expenses exceeding 7.5% of the annuitant’s adjusted gross income may qualify for an exemption. These exceptions aim to provide relief for significant life events.

For certain IRA-funded annuities, up to $10,000 can be withdrawn penalty-free for a qualified first-time home purchase. A new exception under the SECURE 2.0 Act of 2022 allows penalty-free distributions to individuals certified by a physician as having a terminal illness, with a life expectancy of seven years or less. Direct transfers or rollovers of annuity funds to another qualified retirement account avoid the 10% penalty, as funds remain within the tax-advantaged retirement system.