Is There a Penalty for Taking Out an Annuity Early?

Annuities are retirement investment vehicles managed and maintained by life insurance companies. They come in a variety of types, each with its own benefits and advantages. However, regardless of the type of annuity, the tax treatment of those accounts, and the money accumulating within them, is subject to the same rules and penalties. If you own an annuity and are considering a withdrawal prior to reaching retirement age, you should understand the potential consequences of that decision.

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Qualified

Qualified accounts are those containing money that has not yet been taxed. IRAs and employer-sponsored retirement programs like 401k's are prime examples of qualified plans. You receive an income tax deduction for money contributed to annuities within these types of programs. The funds grow tax-deferred until you begin taking distributions in retirement, and only the amount withdrawn is added to your taxable income for the year.

Non-Qualified

Non-qualified accounts contain deposits originating from after-tax dollars. No deduction is received for contributions into non-qualified annuities. However, any growth within the account remains untaxed until it is withdrawn in retirement. When distributions commence, only the portion of each withdrawal deemed growth, as opposed to a return of your original deposit, gets added to your taxable income for the year.

IRS Penalty

The IRS imposes a ten percent penalty for taking money out of an annuity before you reach age 59-1/2. Additionally, any untaxed portion of your withdrawal gets added to your taxable income for the year. An early withdrawal from a qualified annuity, for instance, would result in a taxable income increase for the entire amount. Conversely, an early withdrawal from a non-qualified annuity only results in a penalty and taxes due on the portion deemed growth as opposed to a return of your original deposit.

Surrender Charges

In addition to any IRS penalties resulting from an early withdrawal of annuity money, you may be subject to penalties from the insurance company. Many annuity contracts include surrender charges if money is withdrawn within the first several years after the account is opened. Surrender charges typically last between four and seven years, but an increasing number of annuities have surrender periods of ten or more years. In most cases, the insurance company penalty decreases incrementally every year, until it eventually disappears altogether. Common surrender charges begin around seven percent but may be higher depending on the specific provisions of your annuity.

References

IRS.gov: Retirement Plan FAQs Regarding IRAs
Securities and Exchange Commission: Variable Annuities - What You Should Know
MetLife: Answering Your Questions About Annuities

Article originally published on eHow Business & Personal Finance (03/09/2011)