There are five ways to get out of an annuity without penalties: cancel during the free look period, take a partial withdrawal within the contract’s free withdrawal provision, qualify for a surrender charge waiver based on a hardship, move the money into another annuity through a 1035 exchange, or wait until the surrender charge schedule has run out. Which one fits depends on how recently you bought the contract, how much you need to pull out, your age, and your health.
“Without penalties” has two parts worth separating up front. One is the insurance company’s surrender charge, set by your contract. The other is the IRS’s 10 percent early withdrawal penalty on gains, which applies if you are under 59½. A clean exit avoids both. Some routes avoid one but not the other, so read your contract’s surrender schedule alongside the tax rules below.
Cancel During the Free Look Period
If you just bought the annuity, you almost certainly still have time to walk away with a full refund. Every state requires insurers to offer a free look period. It typically runs 10 days after you receive the contract, and often 20 to 30 days if you are 65 or older. During that window you can return the contract and get your premium back with no surrender charge.
One caveat for variable annuities: the refund may be adjusted for market movement in the account since purchase rather than returning the exact dollar amount you paid. To cancel, notify the insurer in writing before the period expires. Send it by a traceable method and keep a copy.
Use the Free Withdrawal Provision
Most annuity contracts let you take out up to 10 percent of the contract value each year without a surrender charge, even during the surrender charge period. If you need cash but not all of it, this is the cheapest way to get to it. The rest of the balance stays in the contract and continues to grow tax-deferred.
The catch is that a free withdrawal is only free from the insurer’s side. You still owe ordinary income tax on any gains that come out, and if you are under 59½, the 10 percent IRS penalty still applies to the taxable portion. So a free withdrawal avoids the insurer’s fee, but it avoids the IRS penalty only if you fall under one of the exceptions listed further down.
Qualify for a Surrender Charge Waiver
Many annuity contracts include, or offer as an optional rider, a waiver that eliminates the surrender charge when the owner faces a qualifying hardship. The common triggers are:
- Terminal illness certified by a physician, with life expectancy of 12 months or less.
- Nursing home confinement for at least 90 consecutive days in a qualified facility.
- Total and permanent disability, often required to occur before a specified age such as 65.
These waivers usually take effect after the first contract year and require medical documentation.1U.S. Securities and Exchange Commission. Waiver of Surrender Charges Rider Not every contract includes them by default. Call the insurer or check the contract to confirm which waivers you have.
A waiver removes the insurance company’s surrender charge. The IRS side is separate, but two of these situations — disability and death of the owner — are also exceptions to the 10 percent early withdrawal penalty, so both charges can fall away at once.
Move the Money With a 1035 Exchange
If the problem is the annuity itself — poor performance, high fees, wrong product — but you want to stay invested for retirement, Section 1035 of the Internal Revenue Code lets you swap it for a different annuity without owing income tax or the 10 percent early withdrawal penalty. The funds have to move directly from one insurer to the other; if you take possession of the cash, the tax protection is lost.2Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
Permitted exchanges run in specific directions. An annuity can be exchanged for another annuity or for a qualified long-term care insurance contract. A life insurance policy can go to another life policy, an annuity, or a qualified long-term care contract. An endowment contract can go to an annuity or a qualified long-term care contract. You cannot exchange an annuity into a life insurance policy.2Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
Two things to check before you exchange. First, if your current annuity is still in its surrender charge period, the old insurer will deduct that charge before transferring the balance — so the IRS penalty is avoided but the contract fee is not. Second, the replacement annuity likely starts a new surrender charge schedule of its own. Compare the fee structures side by side before signing.
Wait Out the Surrender Charge Period
The simplest way to avoid the insurer’s surrender charge is to wait it out. Find the surrender charge schedule in your policy documents. It commonly starts around 7 percent and drops by roughly one percentage point each year over a period of six to eight years, ending at zero. Once you are past that schedule, you can surrender the contract with no charge from the insurer.
Waiting solves the surrender charge, not the tax. If your goal is also to avoid the 10 percent early withdrawal penalty, timing the surrender for after age 59½ handles both at once.
Age 59½ and Exceptions to the 10 Percent Penalty
The IRS imposes an additional 10 percent penalty on the taxable portion of any annuity distribution taken before age 59½.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: 72(q) Reaching 59½ ends it. Before that, several exceptions eliminate the penalty on non-qualified annuities under Section 72(q):
- Distributions to a beneficiary after the owner’s death.
- The owner becomes totally and permanently disabled.
- Substantially equal periodic payments based on life expectancy, continued for at least five years or until age 59½, whichever comes later.
- The contract is an immediate annuity that begins paying income shortly after purchase.
Qualified annuities held inside an IRA or employer plan follow a broader list of exceptions, including certain medical expenses, qualified higher education costs, and first-time home purchases.4Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
If You Have to Take the Hit
Sometimes the money is needed now, and none of the penalty-free routes fit. In that case, know what you are giving up. The insurer will deduct any surrender charge still in effect based on your contract year. On the tax side, if the annuity is non-qualified, you owe ordinary income tax on the gains, and the IRS treats withdrawals as gains-first under a last-in, first-out rule — so the taxable portion comes out before any tax-free return of your original contributions. If the annuity is qualified, meaning it sits inside an IRA or 401(k) and was funded with pre-tax dollars, the entire distribution is taxable as ordinary income.5Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Under age 59½ and without an exception, add the 10 percent penalty on top of the taxable amount.
When you request the surrender, choose a federal and state withholding amount high enough to cover what you will owe at filing. Annuity gains are taxed as ordinary income, not at the lower capital gains rate, so a large distribution can push you into a higher bracket for the year.
A Note on Structured Settlements
If your payments come from a structured settlement rather than an annuity you purchased, the exit process is different. You sell future payment rights to a factoring company for a discounted lump sum, and the sale has to be approved in advance by a court — federal law imposes a 40 percent excise tax on the transaction otherwise.6Office of the Law Revision Counsel. 26 USC 5891 – Structured Settlement Factoring Transactions The court hearing is required in all 50 states and the District of Columbia. The financial cost is the discount rate rather than a surrender charge or IRS penalty, but it is a real cost, and the process typically takes several weeks to a few months.