Retirement planning is an essential step in financial life. Part of the transition is to ensure that your money is safe and you have income available for the rest of your life. For risk-conscious and lifestyle-minded investors, one instrument to consider for a retirement portfolio is an annuity.
Apart from principal protection, low risk, and tax-deferred growth, annuities can generate a guaranteed lifetime income. This income benefit can help ensure that the contract owner has a constant, dependable cash-flow throughout retirement.
However, there are many aspects of an annuity that people should understand before making a purchase, such as fees and conditions. One of the important conditions set out by annuities are surrender charges.
Let’s take a closer look at what a surrender charge involves.
What is an Annuity Surrender Charge?
You can think of an annuity surrender charge as a deferred sales fee. Most deferred annuities come with a “surrender period.”
The surrender period is a time-frame when excessive early withdrawals, and contract cancellations, are subject to a penalty. Generally, the surrender period tends to run from 5-15 years. The penalty levied on the withdrawn amount is the surrender charge.
To provide some liquidity, deferred annuities come with a “free withdrawal amount.” It’s a specified amount of money that can be withdrawn, annually, without fees. Free withdrawal amounts can vary, but most annuities go up to 10% of the contract value.
Note, if someone makes a contract withdrawal before age 59.5, they may have to pay a 10% penalty on the withdrawal along with ordinary income taxes.
Why do Insurance Companies Charge Surrender Fees?
So, why do annuities come with surrender charges? Here are four reasons:
- It gives the annuity owner an economic basis to stay in the contract.
- It helps to maintain the contractual protections and guarantees to annuity owners, which carriers uphold with dollar-for-dollar reserves for each premium dollar.
- It helps the insurance company keep up its financial strength.
- It serves as an impediment to “runs” on annuity monies. Think of how banks couldn’t hold sufficient reserves for depositors due to bank runs in American history.
When you purchase a deferred annuity, it’s normally a long-term contract. The insurance company invests most of the money into low-risk, long-term options, like investment-grade bonds, as underlying assets. When people pull their money out, it disrupts that long-term investment setup.
From that standpoint, the surrender charge can be seen as a financial “safeguard.” Meanwhile, your contract will earn interest, which will typically be higher than a CD, a regular savings account, or other safe financial choices. It can do that partially because there are surrender fees.
Hence, this is why the company adds surrender charges. Additionally, if you do choose to withdraw earlier, then the fees you have to pay help balance the company’s losses.
How Much do Surrender Charges Cost?
Surrender charges vary by annuity contract, usually ranging from 7-10%.
Normally they cost a percentage of what you withdraw. This could be a flat rate for the entire annuity term, or it could be a variable percentage. Many contracts come with a schedule of declining percentages over the surrender period.
For example, if you withdraw in year 1, then you pay 10%. After that:
- It will go down to 9% in year 2,
- 8% in year 3,
- 7% in year 4,
- 6% in year 5,
- 5% in year 4, and so on.
So let’s say that you had put $100,000 of premium into an annuity contract. You decided to withdraw $16,000 from the annuity due to an emergency, it was Year 1 of the contract, and your surrender charges were 10%. Then you would have to pay $5,000 to the insurance company for the withdrawal. The withdrawal would also be taxable as ordinary income.
In addition to that, if you hadn’t turned 59.5 yet, the IRS would charge an additional 10% tax on your withdrawal. Because the IRS considers annuities a retirement product, they try to discourage withdrawals to support retirement savings.
All of this brings up an important point. When considering an annuity, determine if you will be okay with your money being in the contract for a certain period of years. Evaluate how it affects other things. How might this interplay with other parts of your financial plan? Your purchase should work toward helping you achieve your needs and goals.
If income is a more short-term need, some immediate annuities let you begin receiving income right away. That can be as short as in a month, a quarter, or a year.
What about Contract Bonuses?
If an annuity comes with a premium bonus, chances are the bonus will have to be repaid if the annuity is surrendered or cancelled. Premium bonuses rates can be as high as 10%. So, if the surrender charge is 10%, payback of a 10% premium bonus would bring the surrender penalty up to 20%. If you have heard of surrender penalty amounts falling into this range, it’s likely because the annuity was credited a bonus that was repaid to the insurance company.
Can I Still Get My Money if There is a Surrender Charge?
Simply put, yes, you can get your money out of an annuity early if your term is not yet up. Of course, you will be paying a hefty surrender fee. In addition to that, you may pay taxes.
When considering an annuity purchase decision, it’s prudent to make sure that you are really ready to do so. Make sure you have the funds to diversify your other insurance holdings, your investments, and other assets. If it’s highly probable that you will need to pull funds out early, then other types of financial instruments, besides an annuity, may be better for you.
Also, when considering an annuity, it’s a good idea to make sure that you have sufficient liquidity available for unexpected expenses. Also, evalaute and determine that the amount of money you would put into the annuity does not disrupt your current cash-flow.
Liquidity, financial flexibility, and withdrawal timing are just a few factors behind annuity purchasing decisions. Annuities generally are a longer-term play, and even so, they will make up just part of your plan. The diversification strategy you pursue — annuities, investments, and all — should be right for you and your future.
If you have already decided that annuities are the right choice for you, then read the fine print. Know your surrender charge amounts, when and how you would pay them, and whether you might owe taxes to the IRS.
It’s prudent to research this on your own, so you can ask the right questions and make informed decisions. But working with a financial professional — someone who understands annuity products, their purposes, their downsides, and who guides in your best interest — can make a real difference in your future.
Financial professionals at SafeMoney.com are ready to help you. Use our “Find a Financial Professional” section to connect with someone directly. And if you need a personal referral, call us at 877.476.9723.