What to Do With an Annuity: Withdraw, Convert, Sell, or Inherit

If you own an annuity and are trying to decide what to do with it, you have five real options: take a cash withdrawal, convert the balance into a stream of income payments, exchange it tax-free for a different annuity, sell future payments to a third party, or (if you inherited it) follow the distribution rules that apply to your situation. The right choice depends on your contract’s terms, whether the annuity was funded with pre-tax or after-tax dollars, and your age. Pulling money out before age 59½ can cost you a 10% federal penalty on top of ordinary income tax.¹

Read Your Contract Before You Decide

Two contract details drive every option below. The first is the surrender schedule. Most contracts charge a declining fee if you withdraw money during the first several years. A typical schedule starts at 6% in year one and drops by a point each year until it reaches zero, though schedules run anywhere from three to ten years. Many contracts also include a free withdrawal provision letting you pull a percentage of the account value each year without a surrender charge. Ten percent annually is common; some contracts cap it at 5% or offer nothing. Call your insurance carrier and request a current surrender value statement so you know the exact dollar amount available today after all charges.

The second detail is whether your annuity is qualified or non-qualified. A qualified annuity sits inside a tax-advantaged retirement account like an IRA, 401(k), or 403(b). It was funded with pre-tax dollars, so every dollar that comes out is ordinary income.² A non-qualified annuity was purchased with money you already paid taxes on, so only the earnings portion is taxable when you take it out.

Qualified annuities also carry required minimum distributions. If you turn 73 after December 31, 2022, and before January 1, 2033, you must start taking withdrawals by April 1 of the year after you reach 73. The threshold rises to 75 for anyone turning 74 after December 31, 2032.³ Miss an RMD and the IRS imposes a 25% excise tax on the amount you should have taken. Non-qualified annuities have no RMDs during the owner’s lifetime.

Option 1: Take Cash Out

You can take money out two ways. A partial withdrawal keeps the contract alive; a full surrender ends it and pays out the remaining balance as a lump sum. Partial withdrawals are the common starting point, especially if your contract’s free withdrawal provision covers the amount you need.

How Withdrawals Are Taxed

Non-qualified annuity withdrawals follow a last-in, first-out rule. Every dollar you take out is treated as taxable earnings until the earnings are exhausted, and only then do you start getting your original contributions back tax-free.¹ If you put $100,000 into an annuity that grew to $140,000, the first $40,000 out is fully taxable ordinary income; only after that do withdrawals come from your tax-free basis.

Qualified annuity withdrawals are simpler and more expensive: the entire distribution is ordinary income.² Your insurance carrier reports every distribution to the IRS on Form 1099-R, showing both the gross amount and the taxable portion.⁴

The 10% Early Withdrawal Penalty

Take money out before age 59½ and the IRS adds a 10% penalty on top of the income tax owed on the taxable portion.¹ Several exceptions eliminate the penalty:

Distributions to beneficiaries after the owner’s death.
Total and permanent disability.
Substantially equal periodic payments based on your life expectancy. You must maintain the schedule for at least five years or until you reach 59½, whichever comes later; changing the payment amount early triggers back-penalties with interest.
Payments from an immediate annuity contract.

The IRS penalty is separate from surrender charges. You can owe both on the same withdrawal if you’re young enough and early enough in the contract.⁵

Option 2: Convert the Balance Into Income Payments

Annuitization is the formal process of converting your account balance into a guaranteed stream of payments. The insurance company takes your lump sum and promises checks on a regular schedule. This decision is almost always irrevocable, so the payout structure you choose is the one you live with.

Three standard payout structures are available. Life only pays for as long as you live and stops at death; monthly payments are the highest because the insurer keeps whatever balance remains. Joint and survivor pays until both you and a second person (usually a spouse) have died; payments are lower because the insurer expects to cover two lifetimes. Period certain guarantees payments for a set number of years, such as 10 or 20, with your beneficiary receiving the remainder if you die inside the window; payments stop if you outlive it. Some contracts offer hybrid options combining life and period-certain features. The more protection against outliving your money or leaving something to heirs, the smaller each payment.

How Annuitized Payments Are Taxed

When you annuitize a non-qualified annuity, each payment splits into a taxable portion (earnings) and a tax-free portion (return of your original investment). The IRS calls this the exclusion ratio: total investment divided by expected total return gives a percentage, and that percentage of each payment is tax-free.¹ Detailed calculation instructions for non-qualified plans appear in IRS Publication 939.⁶

Once you’ve recovered your entire investment tax-free, every subsequent payment becomes fully taxable. If you die before recovering your full investment, the unrecovered amount can be claimed as a deduction on your final tax return.¹ Qualified annuity payments follow a different calculation called the Simplified Method, in IRS Publication 575.⁷

Option 3: Exchange It for a Different Annuity

If your current annuity has high fees, poor investment options, or a rider you don’t need, you can swap it for a different annuity without owing taxes on the gains. Federal law allows this through a 1035 exchange.⁸

The rules are straightforward but unforgiving. Funds must transfer directly from one insurance company to the other. If the money passes through your hands, the IRS treats it as a taxable distribution and you’ll owe income tax on the gains plus a possible 10% penalty if you’re under 59½. The exchange must also keep the same owner and annuitant on the old and new contracts; IRS regulations limit tax-free treatment to cases where the same person or persons are the payees under both.⁹

A 1035 exchange can also move money from a life insurance policy into an annuity, or from an annuity into a qualified long-term care insurance contract. It cannot go the other direction: you can’t exchange an annuity for a life insurance policy.⁸ The exchange does not reset the surrender schedule on your old contract. If it still has surrender charges, you’ll pay them when the money leaves, and the new contract starts its own fresh surrender period.

Option 4: Sell Future Payments for a Lump Sum

This option applies mainly to structured settlement annuities, where you’re receiving fixed payments from a legal settlement and want cash instead. A factoring company buys your right to some or all of those future payments for an upfront amount. That amount will be less than the total face value because the buyer applies a discount rate to calculate the present value of money received over time.

Selling structured settlement payments requires court approval in most states. A judge reviews the transaction and determines whether it serves your best interest under state structured settlement protection laws. You’ll need to explain why you need the lump sum and demonstrate the sale won’t leave you or your dependents in financial jeopardy. Court filing fees vary by jurisdiction.

Selling payments from a commercial annuity you purchased yourself (rather than one from a lawsuit) is a different, less regulated process that doesn’t always require court approval. Either way, the tax consequences can be significant, and the discount rates factoring companies charge mean you’ll receive substantially less than the remaining payment total.

If You Inherited the Annuity

Inheritance rules depend on whether the annuity is qualified or non-qualified, when the original owner died, and your relationship to the deceased. Getting this wrong can trigger unexpected tax bills or IRS penalties.

Non-Qualified Annuities

When someone dies holding a non-qualified annuity before the payout phase begins, federal tax law requires the entire balance to be distributed within five years of the owner’s death.¹ You can take the money out in any combination of withdrawals during that window, as long as the account is empty by December 31 of the fifth year.

A designated beneficiary can instead stretch distributions over their own life expectancy, but only if payments begin within one year of the owner’s death. Missing that one-year deadline locks you into the five-year rule.¹ A surviving spouse gets the most favorable treatment: the law treats the spouse as the new owner, so they can continue deferring the annuity and aren’t forced to take distributions at all.

Qualified Annuities and the 10-Year Rule

If the annuity is inside an IRA or employer plan, SECURE Act rules apply for deaths occurring in 2020 or later. Most non-spouse beneficiaries must empty the entire account by the end of the tenth year after the owner’s death, with no option to stretch payments over their own lifetime unless they qualify as an eligible designated beneficiary.¹⁰ That category is limited to surviving spouses, minor children of the deceased (until they reach the age of majority, when the 10-year clock then starts), disabled or chronically ill individuals, and beneficiaries no more than 10 years younger than the deceased owner. Eligible designated beneficiaries can take distributions based on their own life expectancy or choose the 10-year rule; everyone else must follow the 10-year rule with no flexibility.

Spousal Options

Surviving spouses have the widest range of choices for inherited qualified annuities. They can roll the account into their own IRA and treat it as if it were always theirs, resetting the RMD clock to their own age. They can also keep it as an inherited account and take distributions based on their life expectancy, or delay distributions until the deceased would have reached RMD age.¹⁰ The spousal rollover is usually the most tax-efficient path for someone who doesn’t need the money immediately. For non-qualified annuities, a surviving spouse can step into the owner’s shoes and continue the contract as their own, avoiding forced distributions entirely.¹

Filing the Claim

Whichever path you choose, the insurance company will require a certified death certificate and completed beneficiary claim forms before releasing any money. If you’re planning to use the life-expectancy stretch on either a non-qualified annuity or as an eligible designated beneficiary of a qualified plan, the first distribution must begin before the end of the calendar year following the year of death.⁷ Paperwork delays that push you past that deadline can permanently eliminate the stretch option, so file promptly.

1
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Topic No. 410, Pensions and Annuities
3
Federal Register. Required Minimum Distributions
4
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.
5
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
6
Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities
7
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
8
Office of the Law Revision Counsel. 26 U.S.C. 1035 – Certain Exchanges of Insurance Policies
9
Internal Revenue Service. Rev. Proc. 2011-38, Section 1035 Exchanges
10
Internal Revenue Service. Retirement Topics – Beneficiary