Surrendering an Annuity: Beware of Taxes and Surrender Fees

There are many reasons why individuals decide to surrender their annuities. Unfortunately, one of the most common reasons that we see is that individuals realize they were sold the annuity by a broker that was either not in their best interest, or they discover that there are other investment solutions that will better meet their investment objectives. This situation can often lead to individuals making the tough decision to cut their losses and surrender the annuity.  But before surrendering their annuity, it’s important for investors to understand the questions to ask the annuity company about the surrender fees and potential tax liability before making the final decision to end their annuity contract.

Surrender Fee Schedule

Most annuities have what are called “surrender fees,” which are fees that are charged against the account balance in the annuity if the contract is terminated within a specific number of years. The surrender fee schedule varies greatly from annuity to annuity.  Some have a 5-year surrender schedule, others have a 7-year surrender schedule, and some have 8+ year surrender fees.  Typically, the amount of the surrender fees decreases over time, but the fees can be very high within the first few years of obtaining the annuity contract.

For example, an annuity may have a 7-year surrender fee schedule that is as follows:

Year 1:  8%

Year 2:  7%

Year 3:  6%

Year 4:  5%

Year 5:  4%

Year 6:  3%

Year 7:  3%

Year 8+: 0%

If you purchased an annuity with this surrender fee schedule and two years after purchasing the annuity you realize it was not the optimal investment solution for you, you would incur a 7% surrender fee. If your annuity had a $100,000 value, the annuity company would assess a $7,000 surrender fee when you cancel your contract and move your account.

When It Makes Sense To Pay The Surrender Fee

In some cases, it may make financial sense to pay the surrender fee to get rid of the annuity and just move your money into a more optimal investment solution.  If a client has had an annuity for 6 years and they would only incur a 3% surrender fee to cancel the annuity, it may make sense to pay the 3% surrender fee as opposed to waiting 2 more years to surrender the annuity contract without a surrender fee.  For example, if the annuity contract is only expected to produce a 4% rate of return over the next year, but they have another investment solution that is expected to produce an 8%+ rate of return over that same one-year period, it may make sense to just surrender the annuity and pay the 3% surrender fee, so they can start earning those higher rates of return sooner, which essentially more than covers the surrender fee that they paid to the annuity company.

Potential Tax Liability Associated with Annuity Surrender

An investor may or may not incur a tax liability when they surrender their annuity contract.  Assuming the annuity is a non-qualified annuity, if the cash surrender value is not more than an investor's original investment, then there would not be a tax liability associated with the surrender process because the annuity contract did not create any “gain” in value for the investor.  However, if the cash surrender value is greater than the initial investment in the contract, then the investors would trigger a realized gain when they surrender the contract, which is taxed at an ordinary income tax rate.  Annuity investments do not receive long-term capital gain preferential tax treatment for contacts held for more than 12 months like stocks and other investments held in brokerage accounts. The gains are always taxed as ordinary income rates because it’s technically an insurance contract.

Not all annuity companies list your total “cost basis” on your statement.  Often, we advise clients to call the annuity company to obtain their cost basis in the policy and have the annuity company tell them whether or not there would be a tax liability if they surrendered the annuity contract.  You can call the annuity company directly; you do not need to call the broker that sold you the annuity.

If there is no tax liability associated with surrendering the contract, surrendering the contract can be an easy decision for an investor. However, if there is a large tax liability associated with surrendering an annuity, some tax planning may be required.  There are tax strategies associated with surrendering annuities that have unrealized gains, such as if you are close to retirement, you could wait to surrender the annuity until the year that you are fully retired, making the taxable gain potentially subject to a lower tax rate.  We have had clients that have surrendered an annuity, incurred a $15,000 taxable gain, and then turned around and contributed $15,000 more, pre-tax, to their 401(k) account at work, which offset the additional taxable income from the annuity surrender in that tax year.

Is Paying The Surrender Fee and Taxes Worth It?

For investors who face either a surrender fee, taxes, or both when surrendering an annuity contract, the decision of whether or not to surrender the annuity contract comes down to whether or not paying those taxes and/or penalties is worth it, just to get out of that annuity that was not the right fit in the first place. Or maybe it was the right investment when you first purchased it, but now your investment needs have changed, or there is a better investment opportunity elsewhere.  If there are no surrender fees and minimal tax liability, the decision can be very easy, but when large surrender fees and/or tax liability exists, additional analysis is often required to determine if delaying the surrender of the annuity contract makes sense.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.