How can you get out of an annuity?

If you are considering getting out of your annuity early, it is important to understand the financial implications, including taxes, penalties, and missed investment gains. Whether you want to get out of the annuity because you no longer need the annuity or you have found an alternative investment, you have few options to withdraw your money from the annuity. 

You can get out of an annuity by cashing out the annuity. If you cash out during the free look period, you won’t pay surrender charges but there will be tax implications on the withdrawal. If the free look period has expired, you will pay surrender charges as a percentage of the annuity value. If you purchased a return of premium rider, you can get out of the annuity at any time and get a refund of all the premiums you paid.

Ways to get out of an annuity

Getting out of an annuity can be a complicated process, depending on the terms of the annuity contract. Here are ways to get out of an annuity contract:

Free look period

If you cancel the annuity contract during the free-look period, the annuity provider will refund the entire premium you paid penalty-free. Typically, the duration of the free look period varies across annuity providers.

On average, the period may last 10 to 30 days. This period starts when the annuity owner receives the annuity contract. If the free look period has elapsed when the annuity owner cancels the contract, they will pay surrender charges.

Cash out the annuity

If you are no longer interested in the annuity, you can cash out the annuity and receive a lump sum payment. However, when you cash out, you will be required to pay a surrender charge on the annuity.

The amount you pay depends on the surrender charge in the year you cash out. For example, if the annuity has a 10% surrender charge that decreases by 1% each year, and you cash out in the third year, you will pay a surrender charge of 8% of your annuity balance.

If you want to avoid the surrender charges, you can take advantage of the free withdrawals provision up to the allowed limit. Some annuities allow investors to withdraw up to 10% of the annuity balance each year without triggering the surrender charge.

Return of premium rider

When you purchase an annuity, you can add a return of premium rider, which is common with life insurance policies. This rider allows you to get a refund of your premium when you cancel the annuity contract. The return of premium rider is an annuity add-on, meaning you have to pay an extra fee to get this benefit.

When you want to terminate your annuity and trigger the return of premium rider, you will only get the premium you paid, and not the investment growth from your annuity, even if the annuity has grown significantly. Before canceling the annuity, you should weigh how much you will receive against the investment gains you will leave behind.

1035 exchange

If you want out because you don’t like the terms of the annuity, you may be able to swap your annuity into a different type of annuity using a 1035 Exchange. The IRS allows investors to make a 1035 exchange to avoid paying income taxes on the transaction.

When you make a 1035 Exchange, you can swap your annuity for a different type of annuity like a variable annuity or fixed annuity. If you locked in a lower rate with a fixed annuity, you can swap the annuity for a variable annuity to take advantage of higher interest rates that are determined by market forces.

If you swap your annuity, you won’t owe income taxes on the transaction. However, you will pay surrender charges for canceling the annuity during the surrender period. The annuity contract indicates the surrender charge you will pay each year during the surrender period.

Withdrawing money from an annuity

If you want to make an early withdrawal from your annuity, you may be required to pay surrender charges. Annuity providers impose surrender charges to compensate them for the loss of profit when an annuity owner withdraws money prematurely. The surrender charge also discourages annuity owners from using annuities as short-term investments.

Some annuity providers may allow annuitants to withdraw a portion of their funds each year without paying surrender charges. The free withdrawal provision allows annuity owners to withdraw up to 10% of the annual contract. If you withdraw more than the allowed limit, you will owe a surrender charge.

Important considerations before making withdrawals from an annuity

Before you withdraw money from an annuity, there are several factors you should consider:

Age

If you are below age 59 ½ when you make a withdrawal from the annuity, you will incur a 10% penalty in addition to the regular income taxes. The 10% penalty applies to the taxable portion of your withdrawal. However, there are certain exemptions to the 10% penalty, including disability, death, and confinement in a nursing home.

If you are age 59 ½ or older, you won’t owe the 10% penalty; you will still pay the regular income taxes on the withdrawal.

Surrender period

The surrender period is the duration when you must keep the money in the annuity to avoid paying surrender charges. The surrender period ranges between 6 to 10 years, and it varies across annuity providers. Any withdrawals made during the surrender period are subject to surrender charges, which start at a higher percentage in the first year and fall by a specific percentage each year.

Tax implications

When you withdraw money from your annuity, the withdrawal is taxed as ordinary income at your tax bracket rate. You may also pay additional state income taxes if your state taxes annuity withdrawals. If you purchased the annuity with after-tax money, you will only pay taxes on the interest and earnings.