Deferred annuities are a popular choice among individuals seeking to secure their financial future, offering a reliable stream of income during retirement. But life is unpredictable, and sometimes circumstances change, prompting annuity holders to consider surrendering their policies prematurely. Doing so, however, may trigger surrender charges and tax penalties, and also lead to a loss of future income. A financial advisor can help you decide what to do if you’re considering surrendering a deferred annuity.
What Is a Deferred Annuity?
A deferred annuity is a contract you enter with an insurance company, providing you with an income stream at a later time, typically post-retirement. This delay allows the annuity to accumulate value over time.
The first phase of a deferred annuity is known as the accumulation phase. During this period, the annuity holder makes contributions to the account, either as a lump sum or through periodic payments. These contributions grow tax-deferred, meaning that any earnings generated by the annuity are not subject to income tax until they are withdrawn.
One of the key decisions when setting up a deferred annuity is selecting the payout date. This date determines when the annuity payments will begin. Some individuals choose to start receiving income shortly after retirement, while others opt for a later date to allow for more substantial accumulation. The flexibility in choosing this date makes deferred annuities adaptable to various retirement planning strategies.
What Does It Mean to Surrender an Annuity?
When you choose to surrender an annuity, it means you’re opting to terminate the annuity contract before its agreed-upon term or payout period. After all, situations change and an annuity that once seemed like the perfect fit may no longer meet your financial goals or lifestyle needs. Perhaps you have an urgent need for the money that’s invested in the annuity or have been presented with a more lucrative investment opportunity. Or maybe you can no longer afford the premium payments.
How Surrender Charges Work
Surrender charges are one of the primary consequences of early annuity surrender. These fees are incurred when you withdraw funds from the annuity before a predetermined period – often known as the surrender period – has elapsed. but they typically decrease over time, encouraging policyholders to keep their investments intact until the surrender period ends.
Surrender charges and the duration of the surrender period can vary among annuity contracts, but both should be outlined in your annuity contract. These deductions are typically a percentage of the withdrawn amount and decrease over the specified period. For instance, a 7% charge might apply in the first year, shrinking by 1% each ensuing year.
Exceptions to Surrender Charges
It’s essential to note that many annuities offer exceptions or options that allow you to access some of your funds without incurring surrender charges. For example, most contracts allow for penalty-free withdrawals of a certain percentage of your account value each year, often referred to as a free withdrawal provision.
Additionally, some annuities provide riders or features that waive surrender charges under specific circumstances, such as a terminal illness diagnosis.
The specifics tend to differ from contract to contract, underscoring the importance of examining the fine print.
Tax Implications of Surrendering an Annuity
Alongside surrender charges, tax implications of surrendering an annuity early make up another crucial consideration. When you surrender a deferred annuity, any gains you’ve accrued within the annuity are typically subject to ordinary income tax. This is because the growth in your annuity is tax-deferred, meaning you didn’t pay taxes on it when it was earned. Once you withdraw these earnings, they are treated as ordinary income and taxed at your regular income tax rate.
If you surrender the annuity before reaching age 59 ½, you may also be subject to an additional 10% early withdrawal penalty imposed by the IRS. For example, an annuity holder in the 24% tax bracket surrendering an annuity with a $10,000 gain could owe $2,400 in taxes and an additional $1,000 penalty if they are below age 59 ½.
Impact on Retirement Planning
Surrendering a deferred annuity early can disrupt your retirement planning. Annuities are often purchased with the intention of providing a stream of income during retirement. You may lose out on significant accumulated interest. This loss can impact your long-term financial goals, especially if you had intended for the annuity to provide a reliable source of retirement income.
When you surrender the annuity prematurely, you may need to find alternative sources of income to replace the funds you had earmarked for retirement.
Alternatives to Surrendering a Deferred Annuity Early
To potentially circumvent surrender charges, various strategies can be explored, including waiting until the surrender period concludes before withdrawing funds, using partial withdrawals or executing a 1035 exchange to a new annuity.
- Partial withdrawals: Many deferred annuities allow policyholders to make partial withdrawals without surrendering the entire policy. This can be a more flexible option if you need access to some of your funds but want to keep the annuity intact. Keep in mind that partial withdrawals may still be subject to fees and taxes.
- 1035 exchange: Under IRS Code Section 1035, you can exchange your current deferred annuity for another annuity without triggering immediate tax consequences. This allows you to explore better investment opportunities or annuities with lower fees and improved benefits.
- Wait until maturity: If possible, consider waiting until the annuity’s maturity date. Surrender charges are typically reduced or eliminated after the surrender charge period ends, which can last anywhere from several years to a decade.
- Explore loan options: Some deferred annuities permit policyholders to take out loans against the cash value of their annuity. While this isn’t a direct alternative to surrender, it can provide access to funds when needed without fully cashing in the annuity.
There are significant financial implications attached to surrendering a deferred annuity early. Doing so will likely mean paying early surrender charges, income taxes on the distributions, and potentially, an early withdrawal tax penalty. A thorough comprehension of these aspects, coupled with professional financial advice, can help you navigate this complex decision and strive for your financial well-being. As you continue exploring these topics, consider reaching out to a financial advisor to discuss your options and equip yourself better in this intricate financial landscape.
Retirement Planning Tips
- Do you know how much money you’ll need to save to afford retirement? If so, are you on track to hit your savings target? SmartAsset’s retirement calculator can help you answer both questions.
- A financial advisor can help you make important decisions surrounding retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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