The beauty of deferred annuities is the ability to make contributions that grow until you’re ready to withdraw later in retirement. Most annuitants do this to ensure financial stability when their income changes. However, when purchasing an annuity, you’re required to wait a set period of time before accessing any of the funds.
Well, what happens when you need to access those funds, despite the waiting period? Any money taken out of an annuity before the end of the surrender period is subject to surrender charges. Here’s what you need to know.
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Before getting into the details of surrender charges, let’s first establish an understanding of deferred annuities. Essentially, a deferred annuity is a financial product that allows individuals to invest funds for future use by making premium payments. At a later date, typically in retirement, these funds can be accessed and used as income. These annuities come in various forms, but they share a common feature: a surrender charge.
A surrender charge is a fee imposed by the insurance company or financial institution offering the annuity if the contract owner decides to withdraw a significant portion of the invested funds within a specified period, usually during the early years of the contract. This period is often referred to as the surrender period, which can last anywhere from several years to over a decade, depending on the terms of the annuity contract.
The purpose of surrender charges is twofold. First, they act as a deterrent against early withdrawals, encouraging contract holders to keep their funds invested for the long term, as intended with deferred annuities. Second, surrender charges help insurance companies recoup some of the expenses associated with issuing and administering the annuity, such as sales commissions and administrative costs. So, what do these annuity surrender charges actually look like?
Though the goal with surrender charges is to avoid early withdrawals, sometimes they’re just unavoidable. And, since these fees are not just one static value, it’s important to understand how the charge structure changes overtime when you’re evaluating your options for annuities and how they align with your long-term financial goals.
Surrender charges are typically calculated as a percentage of the amount being withdrawn, and the percentage typically decreases over time as the annuity contract ages. For instance, a contract might impose a 7% surrender charge if funds are withdrawn in the first year, but this charge could decrease by 1% each subsequent year until it reaches zero.
As an example, let’s say you purchased a $15,000 annuity in 2020 that has a 5% surrender fee in the first year, and decreases by one percent each year. If you decide to close your annuity after just two years, which is within the surrender period, you would be required to pay a surrender charge of 3% of that initial purchase amount, which comes out to $450. However, in terms of this example, this surrender charge can be avoided by waiting out the five year surrender period before making any withdrawals.
In general, this charge structure is quite simple and is easily applied to annuities that are funded by a lump-sum payment. However, that isn’t the only way to purchase an annuity. Many annuity products use regular premium payments that allow the value to grow overtime, but this also impacts surrender charges if the annuitant were to withdraw from their account before the end of the surrender period.
Surrender charges are ultimately determined by insurance providers, but there are a few factors that go into these calculations. And, when considering deferred annuities, it’s important to understand all aspects of surrender charges before selecting a policy.
As mentioned, annuities can be funded by a single lump-sum payment or regular premium payments. Though regular premium payments allow the annuity to grow, it also adds another layer of complexity to surrender charges.
Perhaps the best way to understand the surrender charges for multiple contributions is to think of each contribution as having its own surrender period. So, using the same $15,000 in 2020 example from above, any withdrawals made within the first five years of the annuity would be subject to surrender charges.
Now, let’s say you never withdrew any money and instead made an additional contribution of $3,000 in 2022 with the same 5% surrender charge in the first year. One year later, in 2023, you decide to withdraw $5,000 from the $18,000 total. At this point, you would be in year 3 of the first surrender period and year 2 of the second, meaning you would pay a 2% fee from the first contribution ($300) and a 4% fee from the second ($120), coming out to a total of $420 in surrender charges to withdraw $5,000 from the annuity.
As discussed, the percentage that determines fees associated with early withdrawals are closely tied to the surrender period. Typically, each year after a contribution is made to an annuity, the surrender charge drops by one percent until it reaches zero. The time needed for this value to reach zero is the surrender period, as outlined in the chart below
| Annuity Year | 1 | 2 | 3 | 4 | 5 | 6 |
| Surrender Charge | 5% | 4% | 3% | 2% | 1% | 0% |
Charge structure and surrender periods play critical roles in how surrender charges are calculated, but so do the specific terms outlined in the annuity contract, as well as the provider offering the annuity. Different insurance companies or financial institutions offering annuities may have varying surrender charge structures and fee levels. Some providers may impose higher surrender charges upfront but offer lower ongoing fees, while others may have more lenient surrender charge schedules but higher annual fees.
Further, policy details, such as optional riders or features, can also impact surrender charges. Additional riders, like guaranteed minimum withdrawal benefits or enhanced death benefits, may come with their own set of fees and potentially affect surrender charges if added to the policy.
Many people are drawn to annuities for their tax benefits, and deferred annuities offer tax-deferred growth, meaning that the earnings on the invested funds accumulate tax-free until they are withdrawn. However, surrender charges can affect the tax treatment of withdrawals in several ways.
When a surrender charge is incurred due to an early withdrawal from a deferred annuity, it's important to recognize that any earnings withdrawn may be subject to ordinary income tax. This tax treatment applies because the earnings within the annuity have been accumulating tax-deferred, and when they are withdrawn, they are taxed as ordinary income, similar to the treatment of withdrawals from traditional IRAs or 401(k) plans.
Additionally, if the withdrawal occurs before the contract holder reaches age 59½, the IRS may impose an additional 10% early withdrawal penalty on the earnings portion of the withdrawal, unless an exception applies. This penalty is separate from any surrender charges imposed by the insurance company or financial institution offering the annuity.
While navigating the taxes associated with annuities, it's essential to distinguish between the tax treatment of withdrawals from the annuity's earnings and withdrawals of the principal amount contributed. Typically, withdrawals of the principal amount are not subject to income tax because they are considered a return of the contract holder's own capital. However, if the annuity was purchased with pre-tax dollars, then withdrawals of principal would be subject to ordinary income tax.
Sometimes, unexpected life events come up and you may need to withdraw from your annuity during the surrender period. Though this may add an unexpected financial strain, know that there are ways to plan for such instances or even be granted exceptions from your insurance provider.
For instance, If the annuitant or contract owner passes away, the surrender charges may be waived entirely. This ensures that beneficiaries can access the funds without penalty and receive the full value of the annuity.
Additionally, some annuity contracts offer provisions that allow for penalty-free withdrawals if the annuitant requires long-term care. Similarly, if the annuitant is faced with a disability, then they may also be excused from penalties. However, each of these instances typically requires documentation to confirm the disability status and may vary based on the terms of the annuity contract.
Finally, once the annuitant reaches age 73, they are required to begin taking minimum distributions (RMDs) from their annuity to comply with IRS regulations. Surrender charges are often waived on these distributions to ensure compliance with tax laws.
The bottom line is that surrender charges aren’t always applied when making early withdrawals. But, it’s still important to factor in the possibility of surrender charges when purchasing an annuity product. Fortunately, ELCO Mutual’s independent insurance agents can help you find a deferred annuity that sets you up for success in retirement. If you’re looking to make a plan to reach your long-term financial goals, reach out to one of our agents today to learn more!