Annuities are insurance products, but they’re more like what you would get if you mixed a life insurance policy with a long-term investment like an IRA or 401k.
Annuities are investments because the end result is guaranteed income payments later in life, usually after retirement. For many people, an annuity is the foundation of a stable retirement.
The life insurance part usually comes into play when you die. At your death, the insurance company pays the total remaining cash value of your annuity to your beneficiaries without penalty. But annuities are like life insurance in another important way, one that can affect you in life: They lack liquidity, a key benefit of market-traded investments. If you want to cash out your annuity early, you may have to pay a penalty, known as a surrender charge.
What Are Annuity Surrender Charges?
An annuity surrender charge is a fee you pay to cash in your annuity early. The surrender charge discourages early cash-outs, protecting the insurance company from financial losses. The concept is similar to early withdrawal penalties on IRAs and 401(k) accounts, though the mechanism is different — whereas IRA and 401(k) early withdrawal penalties are taxes levied by the IRS, annuity surrender charges go to the insurance company.
The typical annuity surrender charge is a percentage of the annuity contract value on a sliding scale. The charge starts at around 10% during the first year and falls by a percentage point or two in each subsequent year until the surrender period expires, usually within 10 to 15 years.
These fees are normal on annuities and standard in various styles, including all deferred annuities like fixed annuities, fixed indexed annuities, variable annuities, and two-tiered annuities.
Keep in mind that the surrender charge isn’t the only fee you may pay for accessing annuity funds early. You may also be required to pay a tax penalty to the IRS if you’re under 59½ years old, and you have to pay ordinary income tax on any gains you withdraw.
How Annuity Surrender Charges Work
Annuity charges are charged as a percentage of the total value of the annuity when you decide to withdraw funds from your annuity early. Understanding how surrender charges work starts with understanding surrender charge periods.
Surrender Charge Period
The surrender charge period is the period of time during which the insurance company will charge surrender charges if you decide to cash out early. The length varies from one annuity contract to the next, but it’s rarely less than five years or longer than 10 years.
For example, if you sign an annuity contract with a five-year surrender charge period, you’re agreeing to keep your money invested in the annuity for a minimum of five years or pay a surrender charge. Once the five-year period expires, you’re free to access your annuity’s value without a surrender charge.
Annuity Surrender Charge Example
Let’s say you signed up for a $25,000 annuity with a 10-year surrender charge period. At five years, you decide you need the funds in your annuity and are willing to pay penalties to access it. According to your annuity contract, the surrender charge is 5% after five years.
Over the five-year period, your annuity’s value has grown to $32,000. So, your annuity surrender charge is 5% of $32,000, or $1,600. This means the surrender value of your annuity is $30,400, or the total value of the annuity minus the surrender charge.
Taking the example a step further, let’s say you decided to access your annuity funds at 49 years old. In this case, the IRS may impose a tax penalty of 10%, or $3,200, leaving you with a total of $28,100 after subtracting all surrender charges and penalties.
Surrender Charge Exemptions
Surrender charges aren’t necessarily set in stone. There are three common exemptions that could get you out of these charges if you need to access the funds in your annuity:
- Terminal Illness. You may be exempt from surrender charges if you’ve been diagnosed with a terminal illness.
- Assisted Living. If you’re an annuity owner and have recently entered an assisted living facility, such as a nursing home, you may qualify for an exemption. This may also be the case if you require home health care for an extended period of time.
- Death Benefit. Your beneficiaries don’t pay surrender charges when they inherit your annuity’s lump sum value.
These exemptions are part of a clause in most annuity contracts regarding your ability to care for yourself. Generally, to qualify for charge-free withdrawal or surrender, you must be unable to meet at least two of six daily living requirements: bathing, dressing, grooming, mobility, self-feeding, and toilet hygiene.
How to Avoid Annuity Surrender Fees
The good news is, most annuity owners never pay a surrender fee. That’s the case even though they access a portion of their annuity’s value before maturity in some cases. See below for some potential ways around your annuity contract’s surrender fee.
1. Act Within the Free Look Period
You are granted a free look period when you sign an annuity contract. This free look period is short, typically between 10 and 30 days from the day you sign the contract. Nonetheless, you have the option to receive all of your money back any time in this free look period without the threat of penalties.
2. Wait Until After the Surrender Period
You only pay surrender fees when you access the cash value of your annuity during the surrender period. So, the best way to avoid these fees entirely is to wait until the surrender period expires before accessing your annuity funds.
3. Withdraw Funds Incrementally
Some annuity contracts will come with a free withdrawal amount. This gives you the ability to access small amounts of money from your annuity when you’re in a bind without paying any additional penalties.
The amount of money you can withdraw usually grows every year you don’t access it. So, only tap into this limited access to funds when you absolutely need it.
4. Buy a No-Surrender (Level-Load) or Immediate Annuity
There are several different types of annuity products on the market, some of which give you immediate access to your annuity funds without penalty. There are two types of annuities worth noting here.
The first is a no-surrender annuity, also known as a level-load annuity. This product is built around the idea of avoiding surrender charges. It works just like any other annuity, but you don’t pay penalties when you access your funds early.
The second is an immediate annuity. You may pay a surrender charge if you need to access the total value of an immediate annuity early. However, these annuities start making income payments immediately when you buy them; these payments may alleviate your need for additional funding.
5. Sell Your Annuity Payments
Several companies make good money by purchasing annuity contracts from annuitants who want out.
If you’ve exhausted your other options, this is worth looking into. Although you won’t get the full long-term value of your annuity, the sales price will likely be higher than the surrender value of your annuity while giving you a way to avoid potential tax penalties.
6. Do a 1035 Annuity Exchange
A 1035 exchange is an IRS-endorsed maneuver that allows you to transfer your annuity to another annuity without tax penalties.
If you need access to your annuity funds now, you may benefit by taking advantage of an exchange and transferring your annuity funds to an immediate annuity for immediate financial relief without penalty.
7. Take Advantage of Exemptions
If you are in a position that allows you to take advantage of surrender charge exemptions, don’t be shy. Take full advantage of them. The three exemptions, including terminal illness, assisted living, and death benefits, are explained in more detail above.
8. Borrow Against Your Annuity
You don’t necessarily have to cash in your annuity to access its cash value. You may be able to borrow against it, avoiding surrender charges and tax penalties.
There is one drawback to doing so. You’ll have to pay interest on the loan, as is the case with just about any other type of loan. The good news is that annuity loans are secured by the annuity and typically come with low interest rates.
Surrender charges are a necessary evil in the annuity industry. They ensure that too many annuity holders don’t cash out too early, putting the insurance companies that offer them in a bind.
If you need to access the funds in your annuity and are unsure of the best way to do so, consider speaking with a financial advisor or another financial professional. They’ll help you decide how your decision will affect your retirement planning efforts, whether or not you’ll have to pay taxes, and other measures you can take to improve your overall financial plan.