Buying an annuity is like planting a sapling fruit tree. It's going to eventually pay off, but you're not going to be eating apples by next week. Annuities are intended to provide long-term, tax-sheltered growth, and then turn those funds into a stable retirement income. Unfortunately, there are times when your needs change and you might need to recover some money you'd already invested. You can cash out an annuity if you need to, but you'll pay the price at tax time.
Taxes on Surrender
When you surrender your annuity, there are two kinds of money you'll get back. Part of it is the amount you've paid into the annuity from your after-tax earnings. Those dollars have already been taxed, and you won't have to pay again. The rest of your balance represents your investment earnings, and those are treated differently. They're taxed as part of your ordinary income for the year, at your highest marginal rate. This is different from mutual funds, which are taxed at a lower rate as capital gains or dividend income.
Annuities are intended to be a vehicle for long-term retirement savings, and their tax-sheltered status is the "carrot" that encourages you to invest. Unfortunately, there's also a "stick" waiting in the wings. Unless you've reached the age of 59 1/2 when you surrender your annuity, the IRS will levy an additional 10-percent penalty on your gains. For example, if your annuity contained $20,000 more than you'd paid in premiums, that penalty will cost you an additional $2,000 as well as the standard taxes you owe.
Aside from taxes, the amount you receive from surrendering your annuity can be whittled away by surrender charges. Annuities are an expensive product for the issuing company. They pay a heavy commission to the broker, as well as the administrative costs of underwriting and issuing contract and managing its investments. Surrender charges are how the company makes back those costs. They can be as high as 20 percent at the start of the contract, and dwindle to zero over a period of several years. On the upside, surrender charges are highest when tax liabilities are lowest, and vice versa.
Surrendering Your Annuity
Between taxation and surrender charges, surrendering your annuity can be an expensive proposition. Be sure you understand the potential downside, before you go ahead with it. The company might have loan or partial withdrawal options that make more sense for you. If you opt to press ahead with surrendering your contract, contact the issuing company and request surrender forms. They'll mail them out or send an agent to your house with them. Return the paperwork in person or by registered mail, and the company will issue a check for your cash value less any surrender charges.
- Comstock/Comstock/Getty Images