Annuities offer the advantage of tax-sheltered growth, which means you won't pay taxes on any of the earnings in the account, but there are steep penalties for taking money out early. Depending on your age and how long you've had the annuity, you could find yourself paying penalties to both your financial institution and the Internal Revenue Service:
Surrender charges are penalties imposed by the financial institution that issues the annuity. These charges typically apply if you cash in your annuity within the first five to seven years of its existence, according to CNN, and can be as high as 20 percent. However, some policies allow you to withdraw a certain amount at any time without penalty, such as 10 percent of your investment. Check your annuity policy for the terms that apply to you.
Early Withdrawal Penalties
If you're under 59 1/2 years old, you're also on the hook for IRS penalties. In addition to the income taxes on the earnings, you also owe a 10 percent early withdrawal penalty, unless you qualify for an exception. For example, say that you take a distribution from your annuity that results in $8,500 of taxable income. If you're under 59 1/2 years old, you also owe an $850 tax penalty on top of the income taxes.
When you take an early withdrawal from your annuity, the IRS treats the distribution as if you took out all of the earnings first. For example, say you invested $5,000 in the annuity today. If two years from now, the annuity has grown to $6,000 and you take a $3,000 distribution, the first $1,000 exhausts all of the earnings in the annuity, so it's taxable and hit with the penalty. Then, the last $2,000 comes out of your contributions, which aren't taxable or penalized by the IRS.
IRS Penalty Exceptions
In some cases, you can wiggle your way out of the 10 percent tax penalty, but not the income taxes, by qualifying for an exception. For example, if you die, the annuity can be paid out to your beneficiaries without penalty. If you're permanently disabled, the penalty is also waived. In addition, the IRS makes exceptions for the portion of your distribution used to pay for medical expenses exceeding 10 percent of your adjusted gross income, qualified reservist distributions, and distributions that are part of a series of substantially equal payments over the remainder of your lifetime.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."