Last updated April 30, 2010
If you’re thinking of dumping your annuity – whether it’s variable, fixed or equity-indexed – consider your options carefully. In many cases, there’s no easy way out.
There are many reasons why you may want out of your annuity. Perhaps you have several annuities you want to combine into one, or your financial situation has changed and you can no longer contribute to your annuity, but certainly could use some cash. Hopefully, you’re not looking to get out because you bought something you didn’t fully understand.
This is what you’ll typically lose by cashing out early:
• A 10 percent penalty on the taxable portion of your annuity is forfeited to the IRS if you’re under age 59½. The tax-deferral rules for annuities were designed to encourage long-term retirement savings, so the penalty is similar to what you’d pay on early withdrawals from an IRA.
• On “fully loaded” products, you’ll pay surrender charges of about 7 percent in the first year, 6 percent the second year, and so on, until the charges no longer apply to withdrawals. No-load or low-load annuities usually carry smaller surrender charges.
• Earnings on annuities are treated as ordinary income, so you’ll pay income taxes on any earnings when you cash out an annuity. That’s in addition to the 10 percent federal tax penalty you’ll pay on earnings if you’re under age 59½.
Because annuities enjoy special tax treatment in the eyes of the IRS, you’d think that there would be tax ramifications for cashing out. But this is not always true. Perhaps you’ve heard of a “1035 exchange” that facilitates tax-free transfers. Section 1035 of the tax code allows for the tax-free exchange between like accounts: annuity to annuity, life insurance policy to life insurance policy, and life insurance policy to an annuity. However, you cannot use a 1035 transfer to go from an annuity to a life insurance policy.
If you surrender an annuity for cash and then buy another annuity, you’ll still pay a tax penalty because the cash has passed through your hands.
If you are using an annuity to fund an IRA, you can rollover to another IRA without tax penalties. Generally you have 60 days from the time you receive the distribution. But beware that investment experts discourage funding an IRA with an annuity because you do not receive additional tax advantages from the variable annuity beyond what the IRA offers.
Most annuities carry surrender or withdrawal fees. Anyone looking to get out of an annuity should consider waiting until the surrender charges no longer apply. If you decide to cash out your annuity no matter what the penalty, you may be able to deduct the loss on your income taxes. Check with your tax adviser on that one.
What are your alternatives?
The 1035 exchange
Use the 1035 exchange to convert to another annuity, but consider one with no load or a lower load than the annuity you now own. Be careful. Talk to your tax advisor to make sure the exchange will be tax-free, and compare both annuities carefully, advises the U.S. Securities and Exchange Commission. You may be better off with your original annuity because the new annuity may include another surrender period.
Look into waivers
If you need cash, read your annuity policy section on withdrawals or waiver benefits. Some annuity contracts, but not many, contain waivers that allow you to access some or all of your money in the event of disability, nursing home confinement, or terminal illness. A few insurers might allow you to withdraw up to 10 to 15 percent of your annuity without penalty under certain circumstances.
Change your fund allocation
Variable annuities grow through gains in investment subaccounts. You choose the distribution of your funds into these accounts. Consider changing your fund allocation to take advantage of the current market. This will not trigger a tax liability and has traditionally been a big selling point of variable annuities.
Slide into an immediate annuity
If you’re thinking about early retirement (prior to age 59½), you might consider rolling your variable annuity into an immediate annuity. By doing so, you’re not really getting out of your annuity, you’re just changing the type of annuity. Although there are still expenses associated with immediate annuities, they do guarantee a lifetime income. More insurance companies are adding options by making adjustments for inflation to your payouts and providing easier access to your assets. Of course, these options come with a price, and it shows up in higher fees.