An annuity can be a powerful financial tool to help you save toward retirement. However, sometimes “life happens,” as the saying goes. A family emergency or unforeseen circumstance can make you consider withdrawing money from an annuity. Depending on your age, the life of the annuity contract and other factors, this can lead to some steep financial penalties. Some annuities do not even offer withdraw or surrender options. Your individual circumstances might make it more advantageous to consider selling future annuity payments, rather than withdrawing from the annuity before it has matured enough.

In this post, we will explore withdrawing money from an annuity, the potential penalties this can trigger, and ways to avoid those penalties if possible.

When Can You Cash Out an Annuity?

You can technically cash out some types of annuities whenever you want. It’s your money, after all. However, doing so risks having to pay financial penalties to the annuity issuer (usually an insurance company), taxes and penalties on the withdrawal to the IRS, or both.

An annuity is a type of financial tool that was created for the specific purpose of providing a reliable stream of income over an extended period of time. Because of that purpose, issuers and the IRS want to discourage people from withdrawing money from an annuity early. The penalties imposed for early withdrawals can be very steep in some conditions. This is why annuity owners should carefully consider the potential penalties before deciding to withdraw cash. It could actually be wiser to sell some future annuity payments, rather than withdrawing funds directly from the annuity.

How Annuity Issuers Handle Early Withdrawals

When you pay money into an annuity, the insurance company that manages the financial vehicle makes its money from the interest earned on your principal. As you pay more money into the annuity over time, the insurance company makes even more money in interest gained. An early withdrawal from an annuity deprives the insurance company of those future interest earnings, which is agreed upon when signing the annuity contract.

An important part of your annuity contract to review is the surrender period and the surrender charge. Most annuities will have a surrender period in which you will be assessed a penalty for withdrawal. This surrender period varies from company to company, but averages six to eight years after you purchased the annuity.

The penalty for an early withdrawal is known as a “surrender fee,” a “surrender charge,” or sometimes a “withdrawal charge.” Once the surrender period on your annuity contract has been reached, you can then make a withdrawal from the annuity without having to pay the full surrender fee.

Surrender fees typically operate on a sliding scale, which reduces over time. Here’s an example of the fees you could potentially pay on an annuity with an eight-year maturity schedule:

• 1 year after purchasing the annuity: 7% fee
• 2 years: 6% fee
• 3 years: 5% fee
• 4 years: 4% fee
• 5 years: 3% fee
• 6 years: 2% fee
• 7 years: 1% fee

After the annuity has matured at eight years from its initial purchase date, some companies will eliminate the surrender fee entirely. Others will keep a 0.5 percent to 1.0 percent fee in place for the remaining duration of the annuity.

Special Circumstances for Early Withdrawals

As we mentioned above, every insurance company is different in regards to early withdrawals and surrender fees. Some companies allow owners to withdraw up to 10 percent of an annuity’s value without incurring a penalty.

However, we should also note that you could find yourself in a situation in which you end up paying a surrender fee, even after the surrender period on the annuity has expired. The terms of your contract will stipulate how much you are allowed to withdraw from an annuity at any one time. Remember, the annuity is supposed to provide a steady stream of payments. Withdrawing a larger sum than allowed has the same effect of cutting into the insurance company’s interest income.

Another special situation to be aware of is that insurance companies allow for situations in which they will waive the early withdrawal penalties entirely. These can include situations like being diagnosed with a terminal illness or being committed to a nursing home. All of these special circumstances are a good reason to read the terms of your annuity contract and how the policy is impacted by early withdrawals.

How the IRS Handles Early Withdrawals

The IRS rules for withdrawing money from an annuity are completely separate from the rules that insurance companies utilize. If the surrender period of the annuity has passed with the insurance company, you may still be subject to the IRS early withdraw penalties and taxes.

The taxes assessed depend on whether it is a qualified or non-qualified annuity. You should seek the advice of a tax professional on how the taxes will be assessed before making a direct withdrawal from your annuity account. For nonqualified annuities, the taxable portion of a withdrawal can be determined by using the General Rule, which is based on the ratio of your investment in the contract to the total expected return.

In contrast, for qualified annuities, you can use the Simplified Method. Under the Simplified Method, you divide your cost by the total number of anticipated monthly payments. For an annuity “that is payable for the lives of the annuitants, this number is based on the annuitants’ ages on the annuity starting date and is determined from a table. For any other annuity, this number is the number of monthly annuity payments under the contract.”¹

Another important note: The IRS always considers early withdrawals from an annuity to be the earnings portion of the account. If you have not reached the age of 59½, you are almost guaranteed to be paying at least some penalty to the IRS.