Can I Get My Money Out of an Annuity? A Guide to Liquidity

Annuities are powerful tools for generating guaranteed income in retirement, but a common question retirees ask is: can I get my money out of an annuity if I need it? The short answer is yes, but it’s not as simple as withdrawing from a savings account. Annuities are designed as long-term contracts with insurance companies, and accessing your funds early can come with costs and restrictions.

Understanding the rules around annuity liquidity is crucial before you purchase a contract. This guide will walk you through how to access your annuity funds, the potential penalties you could face, and the exceptions that might allow you to get your money out penalty-free. We will explore surrender charges, IRS tax penalties, free withdrawal provisions, and other important features that determine your access to your money.

There are three primary ways to get money out of your annuity contract: systematic withdrawals, lump-sum withdrawals, and annuitization. Each method has different implications for taxes and potential penalties, so it’s important to understand how they work.

1. Systematic Withdrawals

A systematic withdrawal allows you to take regular, scheduled payments from your annuity. You can typically choose the amount and frequency (e.g., monthly, quarterly, or annually). This approach is often used to create a predictable income stream in retirement.

• Penalty-Free Withdrawals: Most deferred annuities have a free withdrawal provision that allows you to withdraw a certain percentage of your contract's value each year without incurring a surrender charge. This is often 10% of the previous year's contract value.
• Taxes: You will owe ordinary income tax on the earnings portion of each withdrawal.

2. Lump-Sum Withdrawals

A lump-sum withdrawal, also known as a full or partial surrender, involves taking out a single, larger amount of money from your annuity. This might be necessary for a large, unexpected expense.

• Surrender Charges: If you are still within the surrender period of your contract, you will likely have to pay a significant surrender charge on the amount you withdraw.
• IRS Penalties: If you are under age 59½, you may also face a 10% early withdrawal penalty from the IRS on the earnings portion of the withdrawal, in addition to income taxes.

3. Annuitization

Annuitization is the process of converting your annuity's accumulated value into a stream of guaranteed, periodic payments. These payments can last for a specific period (e.g., 10 years) or for the rest of your life.

• No Surrender Charges: When you annuitize your contract, you do not pay surrender charges.
• Taxes: A portion of each payment is considered a tax-free return of your principal, while the rest is taxable as ordinary income. This is known as the exclusion ratio.

The surrender period is a critical feature of most deferred annuities. It's a set number of years during which you will incur a penalty, known as a surrender charge, if you withdraw more than the penalty-free amount. Surrender periods typically last between three and 10 years, with six to eight years being very common.

The purpose of the surrender period is to give the insurance company time to invest your premium and earn a return. The commission paid to the agent who sold you the annuity is also often recouped during this time. As a tradeoff for this limited liquidity, you receive benefits like tax-deferred growth and protection from market loss.

Typical Surrender Charge Schedule

Surrender charges are usually structured as a declining percentage of the amount withdrawn. The percentage decreases each year until it reaches zero. Here is an example of a typical 7-year surrender charge schedule:

For example, if you have a $100,000 annuity with this schedule and you withdraw $20,000 in the second year (assuming no free withdrawal was taken), you would pay a 6% surrender charge on that amount, which would be $1,200.

While annuities are long-term products, there are ways to access your money while minimizing or avoiding penalties. The key is to understand the rules of your specific contract and the relevant IRS regulations.

1. Utilize Your Free Withdrawal Provision

As mentioned, most deferred annuities allow you to withdraw a certain amount each year (typically 10%) without incurring surrender charges. If you need cash, this should be your first option. Be aware that income tax will still be due on the earnings portion of the withdrawal.

2. Avoid the IRS 10% Early Withdrawal Penalty

The IRS imposes a 10% additional tax on the taxable portion of distributions from annuities before age 59½. However, there are several exceptions to this rule. According to IRS Code Section 72(q), you can avoid the penalty if the distribution is made under the following circumstances:

• You are over age 59½.
• You become totally and permanently disabled.
• The distribution is made to a beneficiary after your death.
• The distribution is part of a series of substantially equal periodic payments (SEPPs).
• You use the funds to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
• The distribution is for qualified higher education expenses.
• The distribution is for a qualified first-time home purchase (up to $10,000, from an IRA-funded annuity).

It is crucial to consult with a tax professional to ensure you meet the specific requirements for any of these exceptions.

3. Plan Ahead for Liquidity Needs

The best way to avoid penalties is to plan for your liquidity needs before you purchase an annuity. Make sure you have enough money in liquid accounts (like savings or money market accounts) to cover unexpected expenses. An annuity should be considered a long-term investment for retirement income, not a source of emergency funds.

In addition to the standard free withdrawal provisions, many annuity contracts include special waivers that allow you to access your funds without paying surrender charges in certain emergency situations. These waivers can provide a critical financial lifeline when you need it most.

Terminal Illness Waiver

If you are diagnosed with a terminal illness and have a life expectancy of a certain period (often 12 to 24 months), this waiver allows you to withdraw some or all of your annuity’s value without surrender charges. You will need to provide a physician’s certification to qualify.

Nursing Home or Long-Term Care Waiver

This waiver allows you to access your funds without surrender charges if you are confined to a qualified nursing home or long-term care facility for a specified period, typically 30 to 90 days. This can help cover the high costs of long-term care.

It’s important to note that these waivers only allow you to avoid the insurance company’s surrender charges. You may still be subject to the IRS 10% early withdrawal penalty if you are under age 59½, unless you meet one of the IRS exceptions.

The availability and terms of these waivers vary by insurance company and annuity product. Always review the contract details to understand what is covered.

Let's consider a real-world scenario to illustrate how these rules work in practice. Linda, a 67-year-old retired teacher, purchased a $200,000 fixed annuity three years ago with a 7-year surrender charge schedule. In the third year, the surrender charge is 5%.

Unfortunately, Linda’s home needs a major roof repair that will cost $25,000. She needs to access funds from her annuity to cover the expense. Let's explore her options:

• Option 1: Use the Free Withdrawal Provision. Linda's annuity allows her to withdraw 10% of her contract value each year without a surrender charge. Ten percent of $200,000 is $20,000. She can withdraw this amount and will only owe income taxes on the earnings portion of the withdrawal. She will still need to find $5,000 from another source to cover the full cost of the repair.
• Option 2: Take a Larger Lump-Sum Withdrawal. If Linda decides to withdraw the full $25,000, she will have to pay a surrender charge on the amount that exceeds her free withdrawal limit. The first $20,000 is penalty-free. The remaining $5,000 will be subject to the 5% surrender charge for year three. The surrender charge would be $250 ($5,000 x 0.05). She will also owe income taxes on the earnings portion of the entire $25,000 withdrawal.
• Option 3: Explore Other Options. Since Linda is over age 59½, she will not have to worry about the 10% IRS early withdrawal penalty. However, if she were younger, she would need to consider if she met any of the exceptions. Given her situation, a SEPP plan would likely not be a good fit as she needs a lump sum. A 1035 exchange would also not be helpful as it doesn't provide immediate cash.

In this case, Linda's best option is likely to use her free withdrawal provision to get the majority of the funds she needs and then supplement with funds from another source to avoid paying surrender charges.

If you are unhappy with your current annuity but don't want to trigger a taxable event, a 1035 exchange can be a valuable strategy. Named after Section 1035 of the Internal Revenue Code, this provision allows you to exchange an existing annuity for a new one without paying taxes on the gains in your original contract.

How a 1035 Exchange Works

To qualify for a tax-free 1035 exchange, you must follow specific rules:

• Like-Kind Exchange: You must exchange an annuity for another annuity.
• Direct Transfer: The funds must be transferred directly from your old annuity company to the new one. You cannot personally receive the money.
• Same Owner/Annuitant: The owner and annuitant of the new contract must be the same as the old one.

A 1035 exchange can be a good option if you want to move to an annuity with better features, lower fees, or a higher interest rate. However, it's important to remember that a 1035 exchange does not get you out of your surrender period. If you are still within the surrender period of your old annuity, you will likely have to pay surrender charges to the original insurance company.

Is a 1035 Exchange Right for You?

Before initiating a 1035 exchange, carefully compare the features and costs of the new annuity with your existing one. Consider the following:

• Surrender Charges: Will you have to pay surrender charges on your old annuity? Does the new annuity have a new surrender charge period?
• Fees and Expenses: Are the fees on the new annuity lower than your current one?
• Features and Benefits: Does the new annuity offer features that are important to you, such as a better death benefit or a more attractive income rider?

Consulting with a qualified financial advisor can help you determine if a 1035 exchange is the right move for your situation.

This article is for educational purposes only and should not be considered financial, legal, or tax advice. Annuities are insurance products and are not insured by the FDIC or any federal government agency. Annuity guarantees are backed solely by the financial strength and claims-paying ability of the issuing insurance company. Retire Wizard is an annuity advisor matching service, not an insurance company. Consult a qualified financial advisor and tax professional for personalized guidance.