I have a significant sum invested in several annuities. I would like to switch that money into index funds and pay taxes as the money is withdrawn. Is this recommended? How would I do this?
Transferring any amount of money from an annuity to index funds is not going to be the simplest process – and it’ll cost you.
What’s missing from your question is why you want to cash out your annuities and invest in index funds instead. My guess is that you’re seeking a higher return and more access to your money. That’s great. But depending on the particulars of your annuity contracts, the costs of cashing out – both literal and implied – may outweigh the potential benefits of an index fund investment, even if the stock market is on a tear.
Consider working with a financial advisor as you evaluate your options on where to put your retirement savings.
How to Get Access to an Annuity’s Value
Annuities tend to have strict rules around when and how you can access their value, and minimizing the financial consequences requires some strategizing. There are two primary ways of cashing out your annuity contracts: surrender or sell.
Surrendering an Annuity
If you cancel an annuity contract early, you’ll likely encounter a fee called a surrender charge. How much you pay depends on your initial agreement with the insurance company and when you entered into that agreement.
Most contracts have surrender periods that can last anywhere from several months to 10 years. As more time passes, your surrender charge decreases. It could go from 7% in the first year, for example, to 6% in the second year and drop another percentage point each year until it reaches zero. Surrender charges can be calculated as a share of either your premiums paid, the value of the contract or your withdrawal amount. Your specific contract will explain how it works.
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Some annuity contracts allow you to pull out some funds each year without incurring a surrender charge. If that option is available to you, that could be more cost effective than taking a lump-sum early withdrawal since your cash needs, it seems, aren’t immediate.
Selling an Annuity
Another way to cash out your annuity is to sell your contract to a third-party company. Instead of a surrender charge, you’ll be subject to a discount rate. The company will knock anywhere from 9% to 18% off the value of your annuity and pay you that amount in cash to buy the contract from you.
Say you have a contract worth $50,000. That’s the overall value of the contract over time. Today, the true value is actually less than that, so the third-party company essentially discounts the value of the contract to reflect time (and give itself a profit, of course).
If you still want to get payments from your annuity in the future, you can arrange a partial sale of your contract. That will allow you to receive one big payment in cash now in exchange for giving up either a set number of periodic payments or a specific portion of your contract value.
Note that if you hold your annuities in retirement accounts, like an IRA or pension, there may be restrictions on sales.
Tax Consequences of Cashing Out an Annuity
Unfortunately, you can’t escape taxes with either route you take. One of the big benefits of an annuity is tax-deferred growth. When you make a withdrawal, either partial or full, those taxes come due. This is true even when you get a regularly scheduled annuity payment.
So whether you surrender your entire annuity contract or sell all or part of your payments, you’ll likely owe taxes on the proceeds. Exactly how much of your distribution is taxable as income depends on the specific type of annuity you have.
Adding insult to injury, the IRS charges an additional 10% penalty on early withdrawals (but not annuity sales) if you’re under age 59.5. For withdrawals from qualified annuities – which are funded with pre-tax dollars, often in traditional IRAs and pension plans – the penalty may apply to your entire distribution. For non-qualified annuities, the penalty may apply only to the earnings portion of your distribution.
As you can see, Uncle Sam takes a big bite out of your haul before you can even pick which index fund you want to invest in. And then, believe it or not, he gets another tax bite whenever you pull money out of your investment account.
Pros and Cons of Cashing Out an Annuity
The literal costs of cashing out an annuity are clear: surrender charges, penalties and taxes can seriously add up. But you should think about the implied costs, too. Giving up an annuity (or two or three) means cutting off a reliable future income stream.
While some types of annuities rely on stock market returns or interest rates to determine payments, the returns you earn through a traditional brokerage account are far more fickle. And they don’t have the benefit of tax deferral. Plus, the stock market is under no obligation to preserve your principal.
To recap, here are some of the pros and cons of cashing out an annuity and putting the money into index funds:
- Use proceeds to potentially earn a higher return
- Regain control over your investments
- Pay a more favorable capital gains tax on your investment withdrawals (assuming you hold them for more than a year)
- A lump-sum withdrawal could put you in a higher tax bracket
- Withdrawals made before age 59.5 are subject to an additional 10% tax
- Eliminates or diminishes future income stream
If cashing out your annuities sounds like the right move, discuss the decision with a financial advisor. Your age, the types of annuities you have and how they currently fit into your retirement plan are all very important considerations.
Tips for Managing Retirement Savings
- Weighing the pros and cons of cashing out an annuity can be a challenge, even confusing. That’s where the insight and guidance of a financial advisor is so valuable. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s no-cost retirement calculator to get a quick estimate of how you’re doing preparing for retirement.
Tanza Loudenback, CFP® is SmartAsset’s financial planning columnist, and answers reader questions on personal finance topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Tanza is not a participant in the SmartAdvisor Match platform.
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