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what is a surrender charge

A surrender charge is a penalty an insurance company charges when an annuity owner cancels or withdraws too much from the annuity before an agreed period of time called the surrender period has passed. Surrender charges can significantly reduce the liquidity of funds placed in an annuity. Surrender periods generally range from eight to 10 years and surrender charges often come to 8% the first year and decline each year after that. It’s a good idea to try and avoid surrender charges, but in certain circumstances, you may not have a choice. A financial advisor can help you figure out how to manage an annuity and decide if one makes sense for you given your financial situation. Try using SmartAsset’s free advisor matching tool to find advisors that serve your area today. 

What Is An Annuity?

An annuity is a contract with an insurance company that guarantees payments for a period of time in exchange for an upfront premium. Immediate annuities start making payments as soon as the contract is signed. Deferred annuities don’t start making payments until some later date, such as a planned retirement date.

Federal income taxes on earnings from investments in an annuity are deferred until the funds are withdrawn. However, withdrawals from an annuity before age 59 1/2 are subject to a 10% penalty, plus being taxed as ordinary income. Withdrawals after age 59 1/2 only incur ordinary income tax. Note that withdrawals are separate from the regular payments that an annuity contract makes.

Annuities are widely used to save for retirement and help meet other long-range financial goals. However, the restrictions on withdrawals due to surrender charges and tax penalties may make things difficult for short-term savers.

Surrender Charges

Surrender charges may be incurred when an individual withdraws money from an annuity early or cancel the annuity altogether. Surrender charges vary significantly depending on the insurance company and the annuity. Although charges are typically around 8% the first year, they can be much higher on some annuities.

When you cancel an annuity, the surrender penalty is applied to the entire amount. For example, if someone cancels a $100,000 annuity with an 8% surrender charge, the penalty would be $8,000.

Withdrawing more than the annual allowed maximum will also trigger a surrender charge. In this case, the surrender penalty only applies to the excess withdrawal. For example, an annuity contract may permit withdrawing $10,000 per year without paying an 8% surrender charge. If the annuity holder withdraws $15,000, a surrender charge of $400 will apply to the $5,000 excess.

Surrender Period

what is a surrender charge

The surrender period is the number of years during which the surrender charge applies. The surrender period may be as short as three years. However, typically the surrender period will be from six to eight years.

The size of the surrender charge normally declines during the surrender period. For example, if it starts at 7% it may decline to 6% the second year. A surrender schedule for an annuity with a starting surrender charge of 7% and a total surrender period of seven years might look like this:

  • First year: 7%
  • Second year: 6%
  • Third year: 5%
  • Fourth year: 4%
  • Fifth year: 3%
  • Sixth year: 2%
  • Seventh year: 1%

No surrender charge would apply to withdrawals in the eighth year and thereafter.

Surrender Charge Exceptions

Immediate annuities, which begin making payments as soon as the contract is signed, typically can’t be surrendered or canceled. So they aren’t subject to surrender penalties.

Insurance companies can also waive surrender penalties if the death benefit provided for in the contract gets paid to the beneficiaries on the death of the insured. The surrender penalty may also get waived if the annuity owner becomes disabled, requires financial help to pay for home health care, enters a nursing home or assisted living center or is diagnosed with a terminal illness.

Other Annuity Charges

Annuity buyers should carefully scrutinize the contract provision for surrender charges and surrender periods. However, a surrender charge is just one of the fees annuity buyers encounter. These can include:

  • Base contract fees of about 1.25% annually
  • Administration fees in the form of a flat fee of about $50 about 0.15% annually
  • Fund expenses charged by mutual funds an annuity invests and passed on to annuity owners
  • Optional add-ons such as long-term car insurance can incur additional fees

The federal tax penalty of 10% for withdrawals before age 59 1/2 represents another sizable potential expense. This fee isn’t charged on withdrawals after age 59 1/2. However, income tax at the individual’s normal rate still applies.

Bottom Line

what is a surrender charge

Annuity owners may have to pay surrender charges if they cancel annuities or make excessive withdrawals before the surrender period ends. Surrender charges can consume 7% to 8% or more of the annuity amount. Surrender periods typically last for eight years or so, with the surrender charge declining throughout the surrender period. Insurance companies often waive surrender charges if the annuity owner dies or becomes disabled. Make sure you’re current on the types of charges you’ll be on the hook for if you decide to withdraw from or cancel your annuity.

Tips for Retirement

  • Figuring out how to save for retirement isn’t always easy. There are lots of good options out there, and it can be hard to make sense of them all. A financial advisor may be able to help you figure things out in a way that works for you. 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.
  • If you’re going about saving for retirement all on your own, it pays to be informed. SmartAsset has you covered with a number of free online resources that can help you manage. For example, check out our free retirement calculator today.

Photo credit: ©iStock.com/shapecharge, ©iStock.com/Sezeryadigar, ©iStock.com/Kemal Yildirim

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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