Surrender periods in deferred annuities: Examples, charges and tax implications

A deferred annuity is a product offered by an insurance company typically meant to provide individuals with guaranteed income at a later date — typically during retirement. During the accumulation (or growth) phase, funds typically grow tax-deferred until you begin withdrawals.

There are three main types of deferred annuities: fixed, fixed indexed, and variable annuities. Withdrawing cash prior to retirement can trigger surrender charges. You may also face an early withdrawal penalty from the IRS and lost future income.  Withdrawals of taxable amounts are subject to ordinary income tax and if made before age 59½, may be subject to a 10% federal income tax penalty. Distributions of taxable amounts from a nonqualified annuity may also be subject to an additional 3.8% federal tax on net investment income.    

This article breaks down what happens if a deferred annuity is surrendered, focusing on tax implications and alternatives.    

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Can a deferred annuity be surrendered?

You can surrender a deferred annuity — partly or fully — during the accumulation phase. Surrender means canceling the contract and/or withdrawing money during the surrender period. People usually surrender annuities to move funds to a different type of investment or because they need cash (liquidity).

Most deferred annuities include a surrender period — typically between 5 and 10 years and varies based on the contract length. During this period, withdrawals that exceed your penalty-free allowance incur a surrender charge and have potential tax implications.

If a deferred annuity is surrendered prematurely, your insurer may apply a positive or negative market value adjustment (MVA) to your account value if interest rates have changed since the beginning of your contract term. If you surrender an annuity early, tax consequences can include ordinary income tax on the withdrawal, plus a 10% IRS early withdrawal tax penalty if you’re under 59-½.    

Full surrender (terminate)

A full surrender cancels the entire annuity contract. You can receive the remaining cash value after applicable surrender charges, any MVA, and taxes are deducted. Terminating the contract effectively ends the contract. That means you give up tax-deferred growth, any future annuity benefits, and may face a taxable event.

Partial surrender/free-withdrawal provisions

Many deferred annuities allow investors to withdraw a certain amount without a surrender charge. You can typically access up to 10% of the cash value annually. If you exceed the free allowance, your insurance company will charge you. And you may still face tax consequences.

Special rules may apply when you surrender an annuity during the accumulation period. For example, some annuities use a rolling surrender charge clock that resets when each premium payment is made, assuming you’re making multiple payments.  

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Who can surrender a deferred annuity contract?

Typically only the owner has the right to surrender a deferred annuity. Your contract should spell out the details. State laws also apply, particularly in the event of death or incapacity.  

There are two important points to consider. Deferred annuities in the accumulation phase typically have a standard death benefit that pays out the contract value or premiums paid minus withdrawals. Payments stop at death — with no remaining value — in annuity payout structures like a straight life annuity, also known as a life-only annuity. Plus, if you don’t name a beneficiary, annuity funds will typically go through the probate process before distribution to your heirs based on the conditions you set in your will.  

Tax consequences of surrendering an annuity

When you surrender a non-qualified deferred annuity, the gain — the difference between cash value and after-tax premiums — is taxed as ordinary income. If you’re under 59-½, you may also owe a 10% IRS early withdrawal penalty on the earnings portion.

The IRS uses the last-in, first-out (LIFO) method to tax deferred annuity earnings. It treats withdrawals as coming from earning first. Your insurance company will issue a Form 1099-R, which shows the taxable amount of the annuity surrender. Because the tax implications vary based on your specific situation, consult a tax pro or your financial advisor before surrendering an annuity.

In a qualified annuity, the entire withdrawal amount is typically taxed as ordinary income. Also, if you’re under 59-½, you may also owe a 10% IRS early withdrawal penalty  

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Alternatives to surrendering

Before you surrender your annuity, think about other options to avoid or lessen the impact of a taxable event and preserve a key component of your retirement plan. The following annuity surrender alternatives can give you access to cash without terminating the contract.  

Use the free withdrawal allowance

Most annuity contracts let you withdraw a portion of your funds without incurring a surrender charge. For example, the Gainbridge FastBreak™ annuity permits withdrawals of up to 10% of the initial premium in the first year or, starting in the second year, up to 10% of the contract anniversary's cash value.

Tax implications depend on the type of annuity: With FastBreak™, you generally won’t incur the IRS 10% early withdrawal penalty because your interest gets taxed annually. However, with the Gainbridge SteadyPace™ annuity, a tax-deferred annuity, you may be subject to the early withdrawal penalty on earnings if you take a distribution prior to 59-½.    

Partial withdrawal

Instead of ending the contract, you can withdraw only the amount of money you need. A partial annuity withdrawal can preserve the remaining contract value, future income, and tax-deferred growth.

Taxes still may apply, and if you exceed the free allowance threshold, you’ll face a surrender charge. But this option can be less disruptive than a full surrender.

1035 exchange

A 1035 exchange lets you transfer funds from one insurance or annuity contract to another without creating a taxable event. The transfer must be direct, meaning you never receive a cash withdrawal. Typically, the owner and annuitant details must also remain the same to qualify for this option.      

Loan or collateralized lines

While not a standard feature, some annuity contracts allow you to borrow against your policy or use it as collateral for a bank loan. This option can provide liquidity without surrendering the contract. However, you’ll likely pay interest, effectively eroding your annuity’s returns or growth.  

Wait out the surrender period

If you don’t need the cash immediately, try to wait. Once your surrender period ends, you have access to the annuity value without surrender charges. At that point, you can withdraw funds without penalties from the insurer. Taxes and the IRS early withdrawal penalty may still apply, but this option can help preserve more of your account value compared to surrendering early.

Annuitize

If you’ve reached retirement age, are seeking income and no longer need tax deferral, you can annuitize your contract. Annuitization converts your annuity in a stream of guaranteed retirement income for a set period or life. While the IRS taxes your annuity payments based on the account type, many insurance companies waive surrender charges because you’re activating the payout phase rather than ending the contract.  

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Deciding whether to surrender a deferred annuity

If you’re thinking about surrendering a deferred annuity, remember that early withdrawals have consequences. They can lead to surrender charges, ordinary income tax, and — if you’re under 59-½ — a 10% tax penalty from the IRS. Before withdrawing money, consider alternatives so your financial goals and retirement income plan remain on track. And if liquidity is important to you may want to consider other products before contributing to an annuity to begin with.

With a 30-day free look period, Gainbridge offers digital-first annuities with flexibility.  

Explore Gainbridge today to compare annuities and find the right mix for your retirement strategy.

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Withdrawals of taxable amounts are subject to ordinary income tax and if made before age 59½, may be subject to a 10% federal income tax penalty. Distributions of taxable amounts from a nonqualified annuity may also be subject to an additional 3.8% federal tax on net investment income. Because they are meant for long-term accumulation, most annuities have withdrawal charges that are assessed during the early years of the contract if the contract owner surrenders the annuity. Please visit gainbridge.com for current rates, full product disclosure and disclaimers and additional information.

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