Annuity Withdrawals During the Accumulation Phase

Buying an annuity at a younger age means tying up the money for a very long period of time.

Buying an annuity at a younger age means tying up the money for a very long period of time.

An annuity is a savings product that can help you build a pile of cash for retirement. In the years before you get to retirement, an annuity is in the accumulation phase, growing tax-deferred. When you get into retirement you can choose to convert the annuity value into monthly income. Taking withdrawals before you get to retirement age can be done, but you may face several unpleasant consequences.

Annuity Surrender Fees

The contract for an annuity includes surrender charges for withdrawing funds in the first years after you purchase it. Depending on the type of annuity and the issuing insurance company, the surrender fees may be in effect for as few as four or five years or for as long as 20 years. These charges can be as much as 10 percent of the amount you take out of your annuity. After the surrender fee period has run its course, the insurance company does not have a claim on part of a withdrawal.

Free Withdrawal Feature

Many annuities do allow limited no-fee withdrawals during the surrender charge period. Typically, if the contract allows withdrawals, up to 10 percent of the accumulated value can be withdrawn without incurring a fee. This feature may be more important to an older person who has purchased an annuity for the tax benefit it provides but wants to have access to the money if the need arises. For a younger person, withdrawing money before retirement should not be part of the plan behind buying this type of investment.

Last In First Out Taxes

A nonqualifying annuity is purchased with after-tax dollars, but the earnings of accumulate and grow tax-deferred. If you take a withdrawal, the IRS applies a last-in-first-out rule on taxing the deferred earnings. This means that the tax agency assumes the untaxed earnings come out first and must be declared on your taxes. For example, assume you bought an annuity for $50,000 and it has increased in value to $55,000. If you take $5,000 out, it will be treated as earnings on which taxes have been deferred and will be included in your taxable income. Any withdrawal amount greater than the interest earned would be a return of your own money and not taxable.

Early Withdrawal Tax Penalty

Earnings taken from an annuity before age 59 1/2 are also hit with a 10 percent tax penalty. The penalty only applies to earnings and not to after-tax money used to buy the annuity. Adding the 10 percent penalty to the LIFO tax rule means that a partial withdrawal from an annuity during the accumulation phase could be heavily taxed, especially if you have not reached retirement age.


About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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