Aviation was still in its infancy when the development of practical parachutes made it possible to "bail out" of a stricken aircraft rather than joining it at the bottom of a smoking crater. The urge to climb out of an impending wreck is familiar to any investor who's experienced a significant downturn in their portfolio's value. With long-term investments such as an annuity, there's often a penalty for getting out. However, annuities often provide what's called a "bailout" clause.
Annuities and Surrender Fees
Internally, your annuity works much like a life insurance policy, except its focus shifts from paying out when you die to paying an income while you live. This involves both insurance calculations and investment management, both of which cost the company. They also pay hefty commissions to the broker. In the first several years of the annuity contract, these costs eat up a large part of your payments. If you want to withdraw money from your annuity during those early years, the issuing company will charge you stiff surrender fees to recover their costs.
Your contract might include clauses that allow you to withdraw your money without penalty, or with minimal penalties, under specific conditions. One set of conditions is related to the returns your annuity guarantees annually. For example, the return during your first year might have been 8 percent, but the company might only be willing to guarantee 4 percent annual returns. Some policies provide you an "out" if the rate declines by a specified percentage at any point in your contract. Others allow a bailout on emergency or hardship grounds, such as a cancer diagnosis that requires all your assets to use for care and treatment.
Earning a pass on your annuity's surrender fees isn't the whole story, unfortunately. Your contributions to the annuity were made with after-tax dollars, so they're not taxable when you withdraw them. That's not the case with any gains in the plan, which become taxable income at your highest rate during the year you make the withdrawal. If you're below the age of 59 1/2 at the time, you'll pay an additional tax penalty of 10 percent on the gains.
Re-Investing Your Bailout
There are limited options for limiting your tax exposure once you've received your bailout. If you have any unused contribution room in your IRA or 401(k), you can use the proceeds from your annuity to top those up and take a corresponding deduction. Alternatively, you could use what's called a 1035 transfer to roll the money into another annuity with more favorable terms, which allows you to continue deferring any taxation on the gains. Your new annuity will also protect itself with surrender fees for a set period. If neither of these options apply to your situation, you'll need to keep back enough money to pay the extra taxes.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.