Although an annuity should be intended as a long-term savings vehicle, you may want or need to get the money out early. As an insurance contract, an annuity is not a marketable security, so you cannot sell it as you would a mutual fund. Instead, you can cash out or redeem the contract or transfer the balance to another account.
Deferred Annuity Function
A deferred annuity is a savings contract that grows tax-deferred until withdrawals are made -- typically to provide retirement income. There are two basic types of deferred annuities -- fixed and variable. A fixed annuity earns interest like a bank certificate of deposit. A variable annuity allows you to allocate the money into different sub-accounts similar to stock and bond mutual funds. Both types of annuities follow the same rules concerning withdrawals or cashing out a contract. The major difference is that a variable annuity may be worth significantly less than the original deposit amount if the sub-accounts have not performed well.
An annuity contract will include withdrawal penalties if the annuity is cashed out within the first several years. The penalty period may be anywhere from a couple of years to 10 years or longer. In the early years of an annuity the withdrawal penalties could be 7 to 10 percent of the amount withdrawn. The penalty rates and how they are applied will be listed in the annuity contract. Some annuities waive withdrawal charges in the event of permanent disability of the annuity owner. Check the contract for a disability clause if you think this may apply.
Taxes and Tax Penalties
Earnings in an annuity contract grow tax-deferred until you make withdrawals. When you cash out your annuity, any gains or earnings will be taxable ordinary income to you, and you must pay income tax on the gain at your marginal tax rate. The tax rules also require the payment of a 10 percent tax penalty if money is withdrawn from an annuity before the owner reaches the age of 59 1/2. The 10 percent penalty applies to any earnings or gains made on the annuity since it was purchased.
Ways To Avoid Penalties and Taxes
If your annuity is also an individual retirement account -- IRA -- the money withdrawn from the annuity can be rolled over into another IRA account to avoid the tax penalty and income taxes due. The rollover IRA can be any type of IRA account. A non-IRA annuity can be transferred to another annuity contract using a 1035 exchange. You cannot take possession of the annuity money to avoid taxes by an exchange. The insurance company issuing the new annuity must request the exchange from the existing insurance company. You may want to use an exchange to move the money to an annuity paying a better rate or to switch annuity types. Any withdrawal fees will still be charged to the account value.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.