Unwinding an Annuity: What You Need to Know

By Financial Advisor Carrie McDonnell

If you’ve ever tried surrendering an annuity contract, you probably know - these products are uniquely designed to make extracting your dollars out of them extremely hard. In fact, that is one common complaint of annuities - most carry a heavy dose of illiquidity risk. If you do find yourself wondering whether that annuity you have is the right investment for you and want to investigate the possibility of surrendering your contract, here are some important questions to address:

What’s an annuity “Surrender Charge”?

A "surrender charge" is a type of sales charge you must pay if you sell or withdraw money from a variable or fixed annuity during the "surrender period”, which typically lasts six to eight years after you purchase the annuity. Surrender charges can be significant and should be considered when deciding if and when to surrender an annuity.

Can I rollover my variable annuity into my IRA?

Qualified Annuities: A qualified variable annuity is a retirement savings investment that is funded with pre-tax dollars. If your qualified annuity is within an IRA or an employer sponsored retirement plan, you can typically rollover the surrender value of your annuity to a Traditional IRA. Once the dollars are in a Traditional IRA, you will have many more investment options available to you.

Non-qualified Annuities: No, if your annuity is non-qualified (or funded with post-tax dollars), you cannot transfer it to an IRA. Instead, you would need to transfer the surrender value to a taxable account, like a brokerage, where you will have a wide range of investment options.

If I surrender my annuity and transfer it to an investment account, do I have to pay taxes?

Qualified Annuities: If you are surrendering your annuity within an IRA and rolling the proceeds to another IRA, this is considered a non-taxable event. Keep in mind, when you start making withdrawals from the IRA, you will pay income tax on the amount withdrawn.

Non-Qualified Annuities: If you surrender a non-qualified annuity, you pay income tax on the earnings. The earnings can be calculated by subtracting the cost basis (or principal) from the surrender value.

Do early withdrawal penalties apply?

Usually. Surrendering an annuity before age 59½ may result in owing a 10% early withdrawal federal tax penalty and income tax on the earnings. The penalty applies only to the taxable portion of your withdrawal—not the principal. However, one exception to this rule is when doing a direct rollover of a qualified annuity into an IRA…once again this is a non-taxable event and will not incur the withdrawal penalty.

What are the financial benefits to surrendering my policy?

Qualified annuities: In many cases you can reduce your expenses from 2%–3.75% per year down to .75%-1% per year by moving an annuity inside of an IRA to a portfolio of low fee index funds managed by a low fee advising firm. These lower ongoing fees can result in significant savings over time. If you can reduce fees by 2% per year on a $100,000 investment, you will save well over $20,000 over a 10-year time frame.¹

Non-qualified annuities: Unwinding these annuities can be painful sometimes. If you’ve held the annuity a long time and the earnings are significant, you will be looking at a sizable tax bill. However, in most cases, you do not want to stay in a poor or inappropriate investment just to avoid taxes. Just like with qualified annuities, you can reduce your on-going expenses significantly by moving to a low fee index fund investment approach, allowing for greater annual growth - often justifying paying the income taxes upfront.

1. https://www.thebalancemoney.com/how-to-surrender-or-exchange-your-variable-annuity-2389026