Need Out of Your Annuity Contract? What Retirees Should Know About Surrender Periods and Charges

A while back, I had a new client who’d made the mistake of going to one of those high-pressure, bait-and-switch golf weekends. After a few hours in a hotel conference room, the poor guy caved and signed away a big portion of his savings in exchange for a high-expense annuity that was more advantageous for the salesman than it was for him. Luckily, he was able to get with another, far better insurance professional who helped him through one of the more difficult parts of having an annuity. Surrendering it.

When It Might Be The Right Choice to Surrender an Annuity

Not all scenarios are like the one above, with a client who was taken for a ride. And in situations like this, you may have a valid complaint against the agent with the insurance company, who may offer to cancel the annuity and refund your money if they find that the transaction was unsuitable or if you were misled.

However, there may be a number of reasons someone might want to surrender an annuity.  One common reason is in the case of a major life change that requires you to get money fast. Since annuities are long-term products designed to supplement income throughout retirement and are not designed to provide significant liquidity, this could cause some clients to run into an issue if significant liquidity is needed.  If you try to take out more than the contract allows, you’re typically going to have to pay surrender charges, which could result in loss of principal and any credited interest. So it’s often not possible to remove a large sum of money from an annuity without incurring surrender charges

In addition, if you have late-life changes, the amount of your annuity’s income payout you need may change. If you get married, you may want a joint contract that provides for your spouse if you die, if your current annuity doesn’t offer this. If inflation moves faster than expected, you may need more growth potential. Sometimes, in this case, transferring an annuity might be an option if there are other products available that may offer different or better growth opportunities.

Finally, the annuity may not perform as you expected, or you may not have fully understood what you were getting into. If you’re suffering from buyer’s remorse, you might be wondering if it’s worth taking the hit on the cost of surrendering. Where you are in your contract will tell you how much that surrender will cost you.

chart51116

The Typical Costs of Surrendering an Annuity

First off, your annuity contract should have a section that specifically discusses surrender fees. Most annuities are set up with a reverse vesting schedule, meaning that the charge for getting out of the annuity goes down the longer you have it. Because annuities are designed as long-term retirement planning vehicles, and enjoy tax deferral as a means to encourage consumers to save for retirement, insurance companies set up surrender schedules to encourage people to stay in the annuity until it reaches maturity

A standard fixed annuity may often feature, for example, a seven-year surrender charge period, as shown in the hypothetical illustration above. During the first two or three years of this annuity, that surrender fee is much higher, and following those years, the fee will taper off until it reaches zero. The fees usually range from 1 to 9 percent of the premium paid, although you may find some outliers that charge more.

Most surrender charge periods start on the start date of the contract, with the anniversary marking the new surrender charge period every year, rather than following a standard calendar year schedule. Also, there are some contracts that will allow you to pull out a certain portion of the funds, usually around 10% of premiums paid or of the annuity value, every year, without incurring a surrender charge. Another thing to note is surrender charge periods apply only to deferred annuities. Immediate annuities will rarely allow any lump sum withdrawal from the product once income payments have started.

Surrender fees apply to both fixed and variable annuities, but with variable annuities, you do have the option of moving the underlying investments within the annuity around. With a fixed annuity, the options aren’t generally as flexible.

A surrender fee is not the only thing that you’ll have to deal with when you’re getting rid of an annuity. When an annuity is surrendered, it becomes taxable income. That means anything you haven’t paid tax on before is due at the time of surrender.

In the case of a qualified annuity, both the principal and the interest will be taxed as regular income. In addition, if you’re under 59½, an additional 10% federal tax penalty will apply. For a non-qualified annuity, taxes will be due on the earned interest, again to be taxed as ordinary income. The 10% federal tax penalty is applied only when the annuity is held in a qualified retirement account.

The hypothetical client we referenced in the beginning of this article, who was unfortunately “duped” by an unethical annuity salesman wound up getting lucky, as he was still within his grace period, which is generally a 30-day period after an annuity in which a consumer is permitted, by state law, to return their annuity for a full refund.

But that’s not always the case. Not getting educated about the annuity they’re buying is the first mistake that many retirees make when they’re looking into the options. That’s why Retirement HQ only works with qualified insurance professionals who focus on educating their clients about annuities, rather than just trying to sell them a product without them fully understanding it.

By contacting RetirementHQ, you may be offered information regarding the purchase of insurance products. All of our financial professionals are licensed insurance agents. Additionally, some individuals may also be registered with a broker/dealer or as an investment adviser.