What Are Annuity Surrender Charges (Everything You Need To Know) 

When you buy a fixed deferred annuity, the insurance company guarantees an annual crediting rate for the length of your annuity contract.

During that period of time, the insurer invests the money. The yield from these investments pays your guaranteed interest rate and earns the insurer a profit.

But what happens when you withdraw your money before your annuity contract term ends?

That's when you must pay surrender charges. Surrender charges are penalties, represented as a percent of your annuity balance, that insurance companies impose if you withdraw funds during the surrender charge period.

In this article, we explain what surrender charges are, their tax implications, and how to avoid surrender charges altogether. But before we delve into the world of annuity surrender charges, let’s review what an annuity product is and its role in your retirement plan.

Annuity Review

Annuities are insurance products offered by insurance companies. Annuity owners commonly use annuities as a part of their retirement planning.

With an annuity, you pay a premium to the insurer (either in a lump sum or through monthly payments).

Then, you receive that money back to you plus interest. Annuities are popular because they're the only product that can provide guaranteed income payments in retirement.

There are many different types of annuities, each with unique features.

Whether or not you may incur surrender charges depends on the type of annuity you purchase, although the majority of annuities on the market have them.

Here’s a simple overview:

When selecting an annuity, you choose when you want to receive your payouts:

• Deferred annuities grow your money over a number of years before paying it back to you. Your annuity accumulates interest over a selected term. When the term ends, you can annuitize the annuity and receive your payouts.
• Immediate annuities start paying you back soon after you buy them. They are typically best suited for those already in retirement or very close to it.

Annuities also let you choose how you want your money to grow.

You can choose this based on which level of risk best fits your personal finance goals:

• Fixed annuities provide a guaranteed minimum interest rate. With this type of annuity, you know the exact growth rate of your account value over the selected term. A fixed annuity is the simplest and safest type of annuity. All Canvas annuities are fixed annuities.
• Variable annuities pay a variable interest rate tied to stock or bond market performance. Funds in variable annuities are usually invested into mutual funds and are much riskier than fixed annuities. Because you don't know how the market will perform, you don't know if your variable annuity will earn any money. It may even lose money.
• Fixed indexed annuities are a hybrid of fixed and variable annuities. They pay an interest rate that is tied to the performance of your chosen market index, but they also have a fixed minimum interest rate—usually 0%. That means you'll never lose any of your initial premium, but you might not gain anything either.

What Does It Mean to Surrender an Annuity?

When you surrender your annuity, you exchange all or a portion of your annuity for its cash value before the end of the annuity contract term.

In other words, you surrender your annuity when you make early withdrawals. For this, you will incur a fee.

Your annuity contract defines your surrender charge period and your surrender charge amounts.

Note: surrendering an annuity is different from selling an annuity. In the latter instance, you sell your payments for less that the total future value.

The Surrender Charge Period

When you purchase an annuity, you agree to a surrender charge period. This is essentially the period of time that you cannot touch your annuity funds (except for emergencies).

The surrender charge period can be as short as 3 years or as long as 14 years; it just depends on your annuity contract terms. If you do decide to withdraw money during the surrender charge period, you will incur a fee.

What Are Annuity Surrender Charges?

Surrender charges are fees that insurance companies charge if you decide to surrender all or part of the money before the end of your annuity contract.

Remember that insurance companies invest the money you put into your annuity. This is how they can pay you the crediting rates on your annuity.

If you want to make an early withdrawal, the insurance company must recoup the cost of liquidating their invested assets.

They do this by assessing surrender charges.

Some companies, like Canvas Annuity, waive surrender charges if the withdrawal is going to certain healthcare costs, including nursing home expenses.

Some companies also provide some liquidity by allowing you to withdraw up to 10% penalty-free each year.

Check your annuity contract to see if you have a free withdrawal amount.

It's important to note that you can avoid surrender charges altogether by not withdrawing money early. The best way to do this? Only deposit money that you will not need during the surrender charge period shown in your annuity contract.

Surrender Percentages

The surrender charge period begins when you purchase your annuity contract. Surrender fees are assessed as percentages of the entire contract value. And surrender charges typically track with each year of the surrender period. For example, you may begin with a 10% surrender charge the first year.

That percentage will slowly decline each year for the term of the surrender charge period. By the end of the surrender charge period, your surrender fee percentage will be 0%.

At that time you can typically let your money continue to accumulate in the annuity, annuitize your contract, or take your money back in a lump sum.

Tax Impact of Surrenders

If you choose to make early withdrawals from your annuity, there may be both surrender charges and tax consequences. For qualified annuities, the IRS charges income tax on the entire annuity cash value.

For non-qualified annuities, you only pay tax on the interest earned. And if you make partial withdrawals from your annuity before age 59 ½, the withdrawal is subject to last-in-first-out (LIFO) tax rules.

Here’s an example of how this works: Let's assume you purchased your annuity for $100,000 and it is now worth $200,000. You make an early withdrawal of $20,000. All of this $20,000 is interest that the annuity has earned.

Under LIFO rules, the entire $20,000 is subject to ordinary income tax because the earnings are taxed first. After you withdraw all the earnings and begin to withdraw your initial premium, the payments are treated as what is known as the owner’s basis.

Also, withdrawals taken before the annuitant reaches age 59 ½ may be subject to a 10% early withdrawal penalty.

Additionally, keep in mind that the 10% penalty-free withdrawals are free from insurance company fees, but not federal taxes.

Add these tax penalties to the surrender charges, and you'll see that early withdrawals should be avoided in all cases except for emergencies.

To learn more, check out our guide to how annuities are taxed.

How to Avoid Surrender Charges

This is simple: Avoid touching any of the money you deposited before the end of the surrender charge period.

Annuities are meant to be long-term investments. Be sure that you can commit to living without your deposit amount for the next 3, 5, or 7 years.

If you’re unsure how much money you can comfortably commit to an annuity, speak with a financial advisor to discuss your investment options and personal finance goals.

Final Thoughts

Annuities are a great option for retirement. But before you purchase one, be sure you understand your contract.

Armed with an understanding of interest rates, guarantee periods, surrender charges, and surrender charge periods, you can make an informed decision and avoid any buyer's remorse.

Additionally, remember to only buy an annuity with money you can comfortably live without for the entirety of the contract term.

This will save you a lot in annuity fees. Finally, remember that your annuity should represent a relatively small portion of all of your retirement accounts.

How the annuity is positioned among all of your retirement savings accounts should be a core point of discussion with your financial professional.

Canvas annuities are among the most simple to understand and buy. Check out Canvas annuities today!

Citations

1. Forbes -- The Gotchas in annuity Taxation (Parrish 2019)
2. The Balance -- Annuity Surrender Periods: Understand (and Avoid) Surrender Charges (Pritchard 2021)
3. Annuity Expert Advice -- What are surrender charges