Annuity withdrawals: What you need to know

If you're saving for retirement, you're likely familiar with annuities. They're a product that could be a good fit for your long-term savings portfolio; like any retirement tool, they shouldn't be relied upon as a short-term savings vehicle. However, life happens, and you might find yourself in a situation where early annuity withdrawals are your only route to fast cash.

If you find yourself considering withdrawing from your annuity early, it's important to know all the factors at play, such as taxes, fees and penalties. Navigating those waters can get tricky. So, let's dive headfirst into the ins and outs of annuity withdrawals so you can make an informed decision.

An annuity is a contract between you and an insurance company where you make one or more contributions and then you can elect to take withdrawals or guaranteed annuity payments after you retire. Annuities are designed to provide a stream of income that can last for the rest of your life, which can be helpful if you're worried about outliving your savings.

In this way, annuities are often used to supplement other sources of retirement income, such as monthly Social Security payments or a pension.

Instead of taking withdrawals, annuities provide various guaranteed income options. These are often referred to as "settlement options" and can create an income for life or a specific period of time. Be sure to review your annuity for your guaranteed income options before taking a withdrawal.

Annuities work in two ways:

• Fixed annuities offer a certain rate of return on the principal that's invested, typically over a set period of time. With this option, you know exactly how much you can earn each year and can plan your financial future accordingly.

• Variable annuities offer potential returns that are determined by fluctuations in the market. While this can be ideal if you're looking to maximize growth, there's the added risk of losing some (or all) of your initial investment if the market takes a turn.

Both types of annuities have advantages and drawbacks and can be great tools for building wealth over time and financial security in your golden years.

An annuity withdrawal is when you remove some money from your annuity, similar to how you would with a checking or savings account. However, withdrawing from an annuity is a more complex process than walking into your bank and using the ATM. Before you make a withdrawal from an annuity, you should verify the terms of the agreement, confirm if there are fees and/or penalties, and make sure you understand the tax implications.

You might choose (or need) to withdraw from your annuity before retirement for several reasons. The most common reason is a need for immediate access to cash during financial hardship, such as a job loss, medical emergency or unexpected expense. Alternatively, you might decide that you'd prefer to invest some of the money that's sitting in your annuity elsewhere.

Whatever the reason, it's important to carefully consider the consequences of an annuity withdrawal before moving forward. Here are a few questions to ask yourself before making an early withdrawal.

If you are younger than 59½ years old and withdraw money from your annuity, the IRS will apply a 10% federal tax penalty on the taxable portion of the withdrawal. This 10% penalty will be in addition to any regular income taxes that apply. There are exceptions to the 10% federal tax penalty for disability, death and certain payment streams.

If you expect to need access to funds prior to age 59½, an annuity might not be right for you.

A surrender charge period is the amount of time that you must keep funds in an annuity to avoid paying penalty charges to the insurance company. The length of the surrender charge period varies, but it's typically between 6 and 10 years. The amount of the surrender charges is typically a percentage of the amount you withdraw. A surrender charge schedule starts as a higher percentage of the withdrawal amount in the first year and then falls by a specific percentage each year. Many surrender charge periods are "rolling," which means a separate surrender charge period applies to each contribution you make to the annuity.

For example, you might be charged a 7% surrender charge if you withdraw funds from an annuity in year one, and the charge declines by 1% each year until after the seventh year when there would be no surrender charge on that contribution.

Make sure you know the terms of your annuity's surrender charge period before you initiate any annuity withdrawals.

Finally, it's important to remember that annuities are taxed as ordinary income, so you may owe taxes on your withdrawals. That means any gains you earn from your annuity fall into your marginal tax bracket and could push you into the next tax bracket.

Here are the tax brackets for the 2023 tax year for single and joint filer filing statuses:

You can withdraw money from an annuity without incurring a surrender charge in a few ways—but it depends on what your provider allows and if you meet specific criteria. For example, there may be exceptions to the surrender charge in your contract. Examples of exceptions include being able to take out 10% each year, job loss, disability or confinement to a care facility.

Overall, there are a few different methods for withdrawing money from an annuity without incurring surrender charges, so it's important to do your research and speak with an expert before making any decisions.

Closing or cashing out an annuity altogether—simply pulling out all your money and shutting down the contract—is an option if you need all of the funds. However, this process may also come with surrender charges, tax implications and the 10% federal tax penalty. So make sure the use for your cash provides more value than the fee you're likely to pay for surrendering your annuity. Proper planning is therefore essential. Before you get started, consider speaking with a financial advisor; they can help guide you through this process.

If you've recently purchased an annuity, annuities offer a "free-look period." This essentially acts as a test-drive period, allowing you to try out the annuity without committing to it for the long term. Check the time frame allowed in the annuity and decide if you'd like to close out the annuity before it elapses.

A 1035 exchange allows you to transfer the money in your existing annuity into a different one. You might consider this if you don't like the current terms in place and wish to change to a different annuity. The IRS allows 1035 exchanges for investors to swap one annuity investment for another without experiencing a tax impact. However, you may need to pay a surrender charge to the annuity provider if you choose this option.

If you have any questions about annuity withdrawals, contact a financial advisor today. They can help you understand the pros and cons of different options and determine which solution is best for your unique circumstances.

Withdrawing money from an annuity can be a complex process, but with the help of a professional, you can make the best decision for your future.