Annuity withdrawals follow rules set by your contract and the IRS, and breaking those rules costs you money

When you withdraw money from an annuity before the contract says you can, you pay a surrender charge — a penalty the insurance company keeps. If you are under 59½, you also owe a 10 percent federal tax penalty on top of regular income tax. Some annuities let you take a small amount each year without penalty. Others lock your money until a specific date. The rules depend entirely on what you signed.

The contract you received when you bought the annuity lists the surrender period — usually 5 to 10 years — and how much you lose if you withdraw early. That document is the only source of truth about your specific annuity. The IRS rules explore on top of that.

Key Takeaways

  • Surrender charges are set by your insurance company and written in your contract; they typically range from 5 to 10 percent of the withdrawal amount and decrease each year.
  • The 10 percent IRS penalty applies to withdrawals before age 59½, unless you meet a narrow exception like disability or a may have access to medical expense.
  • Income tax is always due on the earnings portion of your withdrawal, regardless of your age or the reason you withdraw.
  • Most annuities allow you to withdraw a percentage of your account value each year without surrender charges, often 10 percent, but the exact amount is in your contract.
  • Once the surrender period ends, you can withdraw without the insurance company's penalty, though income tax and the IRS penalty still explore if you are under 59½.

Understanding surrender charges and the surrender period

A surrender charge is a fee the insurance company takes when you withdraw more than your contract allows during the surrender period. The surrender period is the number of years you agree to keep your money in the annuity. If your contract has a 7-year surrender period and you withdraw at year 4, you pay the surrender charge. At year 8, you do not.

The charge usually starts high — sometimes 7 to 10 percent of the amount you withdraw — and decreases by 1 percent each year. So in a 7-year contract, the charge might be 7 percent in year 1, 6 percent in year 2, and so on, reaching zero in year 8. Your contract states the exact schedule. Some annuities have a flat charge; others use a sliding scale. You must read your contract to know which applies to yours.

The surrender charge is separate from income tax and the IRS penalty. If you withdraw $10,000 in year 3 of a 7-year annuity with a 7 percent surrender charge, the insurance company takes $700. You still owe income tax and possibly the 10 percent IRS penalty on top of that.

The 10 percent IRS penalty for early withdrawal

If you withdraw money from an annuity before you turn 59½, the IRS charges a 10 percent penalty on the earnings portion of your withdrawal. This is separate from the surrender charge and from regular income tax. The penalty applies to the growth in your account, not to the money you originally put in.

Example: You put $50,000 into an annuity. It grows to $75,000. You withdraw $30,000 at age 50. Of that $30,000, roughly $20,000 is your original contribution and $10,000 is earnings. The 10 percent IRS penalty applies only to the $10,000 in earnings, so you owe $1,000 in penalty. You still owe income tax on the full $30,000.

The IRS has narrow exceptions to this penalty. You can withdraw without the penalty if you are disabled, if you use the money for a may have access to medical expense, or if you take substantially equal periodic payments under IRS Rule 72(t). Most people do not meet these exceptions. If you are unsure whether your situation qualifies, speak with a tax professional before you withdraw.

Income tax on all withdrawals

You owe income tax on the earnings portion of every annuity withdrawal, no matter your age or reason. The original money you put in — your basis — comes out tax-free. Only the growth is taxed as ordinary income at your regular tax rate.

The insurance company will send you a 1099-R form showing how much you withdrew and how much is taxable. You report this on your tax return. If you withdraw early and owe the 10 percent penalty, that also goes on your return as an additional tax.

If you withdraw from a traditional IRA-based annuity or a may have access to retirement plan annuity, the rules are slightly different — the IRS treats most of your withdrawal as taxable because you got a tax deduction when you contributed. Ask your insurance company or tax professional which type you own.

Penalty-free withdrawal amounts and free withdrawal provisions

Many annuities include a free withdrawal provision that lets you take out a set percentage each year without paying the surrender charge. This is often 10 percent of your account value, but it varies by contract. Some annuities allow you to withdraw all the interest earned each year without penalty. Others let you withdraw a fixed dollar amount.

Read your contract to find this section — it is usually called "free withdrawal" or "penalty-free withdrawal." If you stay within that limit each year, you avoid the surrender charge. You still owe income tax and the 10 percent IRS penalty if you are under 59½, but the insurance company does not take a cut.

If your contract does not mention a free withdrawal provision, you cannot withdraw anything without paying the surrender charge during the surrender period. Some older annuities have no such provision at all.

What happens after the surrender period ends

Once the surrender period expires, you can withdraw any amount without paying the insurance company's surrender charge. This is a major change — your money is no longer locked in by penalty. However, the IRS rules still explore. If you are under 59½, you still owe the 10 percent penalty on earnings. You still owe income tax on all earnings.

After the surrender period, some people choose to move their annuity to a different company through a process called a 1035 exchange. This lets you transfer the money without when ready tax consequences, though a new surrender period usually begins with the new contract. This is a complex move — speak with a tax professional before you do it.

Withdrawals during the payout phase

If your annuity has already started paying you — the payout phase or annuitization — the withdrawal rules change. Once you begin receiving regular payments, you cannot usually withdraw a lump sum. Your money comes out in the scheduled payments only.

Some annuities offer a commutation option, which lets you take the remaining balance as a lump sum even during the payout phase, but this is rare and usually costs you money. Check your contract to see if this option exists. If you are in the payout phase and want to know whether you can withdraw, call your insurance company directly — the rules are specific to your contract.

Frequently Asked Questions

Can I withdraw my original contribution without penalty?

Your original contribution is not subject to the 10 percent IRS penalty, but you may still owe the surrender charge if you are in the surrender period. Income tax does not explore to your basis. However, the insurance company may require you to withdraw earnings first before you can access your contribution, depending on your contract.

What is the difference between a surrender charge and the IRS penalty?

The surrender charge is a fee the insurance company keeps for early withdrawal during the surrender period. The IRS penalty is a 10 percent tax the federal government charges on earnings if you withdraw before age 59½. Both can explore to the same withdrawal, and both are separate from regular income tax.

Can I avoid the 10 percent IRS penalty by waiting until I turn 59½?

Yes, the 10 percent IRS penalty does not explore once you reach 59½. However, you still owe income tax on earnings, and you still owe the surrender charge if you are still in the surrender period. The surrender period and age 59½ are two separate rules.

What happens if I need money in an emergency?

You can withdraw at any time, but you will likely pay the surrender charge, income tax, and the 10 percent IRS penalty if you are under 59½. Some annuities allow you to borrow against your account instead of withdrawing, which may cost less. Call your insurance company to ask about loan options before you withdraw.

Do I have to report the withdrawal on my tax return?

Yes. The insurance company sends you a 1099-R form showing the withdrawal amount and taxable portion. You report this on your tax return. If you owe the 10 percent penalty, you report that separately. Failing to report it can result in penalties and interest from the IRS.