Are There Penalties for Withdrawing Money from Annuities?

Unfortunately, yes—levied both by the IRS and by the issuer

Reviewed by Marguerita Cheng
Fact checked by Suzanne Kvilhaug

Annuities can be great investments for retirement savings and estate planning, but they come at a cost. If money is withdrawn from an annuity prior to the term of the contract, the insurance company usually assesses a surrender charge for early withdrawal.

The Internal Revenue Service (IRS) may also assess a premature penalty of 10% and income tax on the withdrawn funds. The amount of the surrender charge depends on how long the owner stayed in the contract. The penalty for early withdrawal depends on the age of the contract holder and the circumstances for making the withdrawal.

In early January 2020, then-President Donald Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Part of the act is expected to make annuities more popular. First, the act created a “fiduciary safe harbor” that lowers the risk that a plan participant will have to sue a plan fiduciary if the insurance company cannot pay on the annuity as promised.

Additionally, annuities sold inside qualified plans are now more portable. If the annuity option is taken out of the plan, the participant can roll it out of the plan “in-kind” rather than having to liquidate the option.

Key Takeaways

• Withdrawals from annuities can trigger one of two types of penalties.
• The insurer issuing the annuity charges surrender fees if funds are withdrawn during the annuity’s accumulation phase.
• The IRS charges a 10% early withdrawal penalty if the annuity holder is under the age of 59½.

Annuity Surrender Charges

Annuity contracts are issued by insurance companies for a specified investment term, typically from four to eight years. Also known as the accumulation phase, this is the period during which your initial lump sum is supposed to grow, accumulating the funds that will be paid out to you later in the annuitization phase. This means that any withdrawal you make during this period incurs a surrender charge.

For each year the investment is held, the penalty for early withdrawal changes, decreasing lower the longer the annuity is held. This is called a surrender schedule. It is not uncommon for an early withdrawal penalty made in the first few years of owning an annuity to exceed 5%. For example, an annuity with an investment term of eight years might have a surrender charge of 8% in year one after you sign up, 7% in year two, and so on, dropping one percentage point annually until year eight.

Tax Penalties on Annuities

In addition to penalties assessed by the insurance company, early withdrawals may also trigger an IRS penalty—specifically a 10% withdrawal penalty, the same fee levied on early distributions from a 401(k) or individual retirement account (IRA).

Why? Annuities are considered a retirement product by the IRS regardless of whether or not the contract is held in a qualified retirement plan (which usually isn’t a good idea, anyway). Even non-qualified annuities (those purchased with after-tax dollars and not held in a retirement account) require the owner to reach the age of 59½ before taking penalty-free distributions.

Important

Along with penalties, early withdrawals from annuities may also be subject to income taxes calculated at your regular income tax rate (generally, any earnings minus the original amount you invested in the annuity).

The 10% penalty applies to the earnings portion of a withdrawal—which doesn’t sound too bad, except that, when it comes to annuities, the IRS assumes that earnings are withdrawn first (not your original investment).

Exceptions to Annuity Penalty Rules

Fortunately, like retirement accounts, annuities allow for early withdrawal with no penalty in the event the annuitant becomes disabled or dies. Additionally, some contracts offer a benefit for taking penalty-free withdrawals to pay for long-term care expenses.

Many annuity contracts also let the owner withdraw up to 10% of the contract value or premium each year, as defined in the contract, penalty-free.

What Are Annuities?

An annuity is a contract that’s issued and distributed by an insurance company and bought by individuals. The insurance company pays out a fixed or variable income stream to the purchaser beginning right away or at some time in the future in exchange for premiums they’ve paid.

How Did the SECURE Act of 2019 Affect Annuities?

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 was expected to make annuities more popular by:

• Creating a “fiduciary safe harbor” that lowers the risk that a plan participant will have to sue a plan fiduciary if the insurance company cannot pay on the annuity as promised.
• Making annuities sold inside qualified plans more portable. If the annuity option is taken out of the plan, the participant can roll it out of the plan “in-kind” rather than having to liquidate the option.
• Encouraged plan sponsors to include annuities as an option in workplace plans by reducing their liability if the insurer cannot meet its financial obligations.
• Encouraged employers to include more annuities in 401(k) plans by removing their fear of legal liability if the annuity provider fails to provide, and not requiring them to choose the lowest-cost plan.

How Did the SECURE 2.0 Act of 2022 Affect Annuities?

The SECURE 2.0 Act of 2022, which was signed into law by then-President Joe Biden on Dec. 29, 2022, as part of the Consolidated Appropriations Act (CAA) of 2023, increased the amount that individuals can move to a qualified longevity annuity contract (QLAC) from $125,000 to $200,000. It also adjusted the $200,000 limit annually for inflation and eliminated the rule capping QLAC premiums at 25% of the participant’s total plan assets.

A QLAC is a deferred annuity funded with an investment from a qualified retirement plan or an IRA. It allows funds in a qualified retirement plan, such as a 401(k), a 403(b), or an IRA, to be converted into an annuity.

The SECURE 2.0 Act also removed availability barriers to some life annuities in tax-advantaged retirement accounts and allowed a retiree with a partially annuitized plan to combine the payments from the annuity and the plan in order to calculate their required minimum distribution (RMD).

The Bottom Line

Annuities can be great for retirement savings and estate planning, but withdrawals can trigger one of two types of penalties. The insurer issuing the annuity assesses surrender fees if funds are withdrawn during the annuity’s accumulation phase, and the IRS charges a 10% early withdrawal penalty and income tax on the withdrawn funds if the annuity holder is younger than 59½.