Annuity Surrender Charges: What They Cost and How to Avoid Them

When you buy a deferred annuity, the insurer invests your premium in long-term bonds and other assets to back the interest rate or index credits it promised you. It also pays the agent's commission up front, from its own funds. If you leave in the first few years, the company has not yet earned back those costs, so the contract lets it keep a percentage of what you withdraw. That percentage is the surrender charge.

The charge is not a penalty for bad behavior; it is the price of the guarantee. Because the insurer knows most buyers will stay for the full period, it can commit to a higher credited rate than a product that has to keep every dollar liquid. A contract with a longer surrender period will usually carry a higher guaranteed rate than one with a short period, for exactly this reason.

You will find the schedule in the contract's surrender or withdrawal provisions, and again on the statement of benefits the agent must give you before you sign. If you cannot find it, ask; the agent is required to disclose it.

Takeaway: The surrender schedule is the single most important page of a deferred annuity contract. Read it before the rate.

Surrender periods commonly match the rate guarantee on a multi year guaranteed annuity (a 5-year MYGA usually has a 5-year schedule) and run 7 to 10 years on many fixed index annuities. The charge in year one often sits between 7% and 10% and drops by roughly one percentage point a year until it reaches zero. Some contracts start lower; a few start higher and decline faster.

The table below is an illustrative example of a 7-year schedule. It is not a quote from any company. Your own contract may differ in the starting percentage, the length, and whether the year counts from the contract date or from each premium payment.

Almost every deferred annuity lets you take some money out each year with no surrender charge. The common allowance is 10% of the account value once a year, often available after the first contract anniversary. Some contracts use 10% of the premium rather than the current value; some allow the interest earned instead of a percentage; and some let unused free amounts carry forward for a year. The contract defines which you have.

Two details matter in practice. First, a free withdrawal is free of the contract charge only; income tax and, before age 59 and a half, the IRS additional tax can still apply to the taxable portion. Second, taking the free amount usually does not reset the surrender clock, but making a full surrender or a large partial surrender does end the contract or shrink the base your future free amount is measured on.

Required minimum distributions from an annuity held inside an IRA are treated as free withdrawals by nearly every contract, even when they exceed 10%, because the insurer knows the IRS requires them.

Many fixed and fixed index annuities carry a market value adjustment, or MVA, on top of the surrender charge. An MVA ties the amount you receive on an early withdrawal to what has happened to interest rates since you bought. If rates have risen, the bonds backing your contract are worth less, and the MVA reduces your payout. If rates have fallen, those bonds are worth more, and the MVA increases what you receive. It works in both directions.

Here is the direction of the effect with made-up numbers. Suppose you bought a contract when comparable rates were 4% and you want to surrender with two years left while comparable rates are 5%. The MVA would subtract an amount that grows with the size of the rate move and the years remaining. Had rates fallen to 3% instead, the MVA would add an amount. The formula and the reference rate are in the contract; most cap the adjustment so it can never take you below your guaranteed minimum value.

MVAs do not apply to free withdrawals, to withdrawals after the surrender period, or to the death benefit in most contracts. They are the reason two people surrendering identical contracts in different years can receive different amounts.

Takeaway: An MVA can hurt you when rates have risen and help you when rates have fallen. Ask which way it points before you surrender.

Most contracts waive the surrender charge in certain situations, and these waivers are common enough that their absence is worth noticing. The usual list: confinement in a licensed nursing home for a set period, often 60 to 90 consecutive days, beginning after the contract is issued; diagnosis of a terminal illness with a life expectancy of a year or less; and death, where the beneficiary receives the death benefit without any charge. Some contracts add disability, unemployment, or home health care.

Waivers are contract features, not legal guarantees. They vary by product and by the state where the contract was issued, some require a waiting period after purchase, and some require the condition to arise after the contract date. Read the waiver section, and if you are buying for a spouse or parent whose health is already a concern, confirm in writing which waivers will actually apply.

• Nursing home confinement, typically after a set number of consecutive days.
• Terminal illness, usually defined as a physician-certified life expectancy of 12 months or less.
• Death of the owner or annuitant, with the death benefit paid free of surrender charges.
• Sometimes: disability, unemployment, or required minimum distributions above the free amount.

Work the cost in four steps. Start with the account value on your latest statement. Subtract the free withdrawal amount you are still entitled to this year; the surrender charge applies only to what is left. Multiply that remainder by the charge percentage for your current contract year. Then apply the market value adjustment if your contract has one and you are still in the adjustment period.

What you receive is the account value minus the surrender charge, plus or minus the MVA. If that figure is less than the contract's guaranteed minimum value (a floor most state laws require), the insurer pays the floor instead. Then estimate the tax: the taxable portion of the withdrawal is ordinary income, and if you are under 59 and a half, add the 10% federal additional tax on that taxable portion.

Compare that total cost with the reason for leaving. Moving to a contract that credits one percentage point more does not pay for a 6% surrender charge for many years. Moving because you need the cash for a medical bill or a house may be worth it, and a partial surrender up to the free amount plus a small excess often costs far less than a full surrender.

People confuse these two because both are often described as penalties. They come from different places. The surrender charge is written into your contract by the insurance company and applies by contract year, regardless of your age. The 10% additional tax comes from federal tax law and applies to the taxable part of a withdrawal taken before age 59 and a half, regardless of contract year, with exceptions for death, disability, and payments taken as a series of substantially equal periodic payments.

A 62-year-old in year two of a contract owes a surrender charge on excess withdrawals but no IRS additional tax. A 55-year-old in year twelve owes no surrender charge but may owe the additional tax on the taxable portion. A 55-year-old in year two can owe both. Annuitizing the contract for your lifetime or life expectancy generally avoids the IRS additional tax, because lifetime payments are an exception to it; a payout over a fixed number of years does not qualify on that ground. In most contracts annuitizing also avoids the surrender charge.

Section 1035 of the tax code lets you move the value of one non-qualified annuity directly to another annuity without recognizing the gain as income. The money must go insurer to insurer; if the check comes to you first, it is a taxable withdrawal. The same rule lets you exchange an annuity for a qualified long-term care insurance contract. It does not run the other way for life insurance: an annuity cannot be exchanged tax-free for a life insurance policy.

An exchange avoids tax, but it does not avoid the surrender charge. If you exchange during the surrender period, the old insurer still deducts its charge (and any MVA) before sending the balance, and the new contract starts its own surrender schedule from zero. An exchange makes sense when the surrender period on the old contract has ended or nearly ended, and the new contract offers a materially better guarantee, a needed rider, or a stronger insurer. It rarely makes sense in the first few years, and agents are required under state suitability rules to document why a replacement benefits you.

Takeaway: A 1035 exchange saves the tax, not the surrender charge. Time the exchange for the end of the schedule.

Your statement may show two numbers. The account value (or accumulation value) is the premium plus all interest or index credits, minus prior withdrawals and any rider fees. The cash surrender value is what you would actually receive if you cashed out today: the account value minus the current surrender charge, adjusted for any MVA, and never below the guaranteed minimum value. During the surrender period the cash surrender value is lower; after it ends the two numbers are the same.

Income riders use a third figure, the benefit base, which sets the guaranteed withdrawal amount but is never available as a lump sum. Confusing the benefit base with the cash value is one of the most common annuity misunderstandings, and it is worth asking the agent to point to each number on a sample statement before you buy.