If you and your partner are thinking of purchasing your first home or need a little extra cash for your dream vacation, you may be thinking of raiding that annuity you purchased a few years ago. However, if you cash out before you turn 59 1/2, you could face not only taxes and penalties from Uncle Sam, but also surrender charges from your financial institution.
Taxes on Distributions
When you cash out your annuity, the money you receive gets split into two categories: returns of contributions and earnings. The returns of contributions aren't included in your taxable income because your deposits are made with after-tax dollars. In other words, you don't get a deduction on your taxes for contributing to an annuity. However, the earnings portion counts as taxable income and is taxed at your ordinary rate. For example, say you cash out a $20,000 annuity and $15,000 of it counts as a return of contributions. If you fall in the 25 percent tax bracket, you owe $1,250 in taxes on the $5,000 of earnings.
Early Withdrawal Penalties
The Internal Revenue Service also slaps an extra 10 percent tax on the taxable portion of your annuity withdrawal. For example, say that you cash out $20,000 from your annuity when you're 30 years old and that $5,000 counts as taxable income. Not only do you pay taxes on the $5,000, the IRS also tacks on an extra $500 tax penalty because you're taking an early withdrawal.
In a few, limited circumstances, you can avoid the 10 percent early withdrawal penalty, but not the income taxes, when cashing out your annuity early. Exceptions include if you become permanently disabled or if you're taking a series of substantially equal distributions. You can also take the money out penalty-free if you inherited the annuity from a decedent. For example, if you inherited the annuity from your grandparent, you can take the money out penalty-free any time you want.
Even though you might qualify for a penalty exception, the financial institution offering the annuity might have its own set of early withdrawal penalties to hit you with. According to the Texas Department of Insurance, surrender charges typically range from 5 to 25 percent, but usually go down over time. If you've only had the annuity for a short period of time, you could see a large chunk of your distribution shared with Uncle Sam and your bank.
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."