Annuities can be a great investment for retirement savings and estate planning, but they come at a cost. If money is withdrawn from an annuity before the contract specifies, the insurance company usually assesses hefty penalties. The Internal Revenue Service (IRS) may also assess income tax penalties on the withdrawn funds. The amount of the penalty depends on the investor's age at the time of withdrawal, how long the investment has been held, and the circumstances for making the withdrawal.
In early January 2020, former President Donald Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Part of the act is expected to make annuities more popular. First, the act has created a “fiduciary safe harbor” that lowers the risk that a plan participant will have to sue a plan fiduciary if the insurance company cannot pay on the annuity as promised.
Additionally, annuities sold inside qualified plans are now more portable. If the annuity option is taken out of the plan, the participant can roll it out of the plan “in-kind” rather than having to liquidate the option.
- Withdrawals from annuities can trigger one of two types of penalties.
- The insurer issuing the annuity charges surrenders fees if funds are withdrawn during the annuity's accumulation phase.
- The IRS charges a 10% early withdrawal penalty if the annuity-holder is under the age of 59½.
Annuity Surrender Charges
Annuity contracts are issued by insurance companies for a specified investment term, typically from four to eight years. Also known as the accumulation phase, this is the period during which your initial lump sum is supposed to grow, accumulating the funds that will be paid out to you later in the annuitization phase. This means that any withdrawal you make during this period incurs a surrender charge.
For each year the investment is held, the penalty for early withdrawal changes, decreasing lower the longer the annuity is held. This is called a surrender schedule. It is not uncommon for an early withdrawal penalty made in the first few years of owning an annuity to exceed 5%. For example, an annuity with an investment term of eight years might have a surrender charge of 8% in year one after you sign up, 7% in year two, and so on, dropping one percentage point annually until year eight.
Tax Penalties on Annuities
In addition to penalties assessed by the insurance company, early withdrawals may also trigger an IRS penalty—specifically a 10% withdrawal penalty, the same fee levied on early distributions from a 401(k) or individual retirement account (IRA).
Why? Annuities are considered a retirement product by the IRS regardless of whether or not the contract is held in a qualified retirement plan (which usually isn't a good idea, anyway). Even non-qualified annuities (those purchased with after-tax dollars and not held in a retirement account) require the owner to reach the age of 59½ before taking penalty-free distributions.
Along with penalties, early withdrawals from annuities may also be subject to income taxes calculated at your regular income tax rate (generally, any earnings minus the original amount you invested in the annuity).
The 10% penalty applies to the earnings portion of a withdrawal—which doesn't sound too bad, except that, when it comes to annuities, the IRS assumes that earnings are withdrawn first (not your original investment).
Exceptions to Annuity Penalty Rules
Fortunately, like retirement accounts, annuities allow for early withdrawal with no penalty in the event the annuitant becomes disabled or dies. Additionally, some contracts offer a benefit for taking penalty-free withdrawals to pay for long-term care expenses.
Many annuity contracts also let the owner withdraw up to 10% of the contract value or premium each year, as defined in the contract, penalty-free.