Annuities are investments that are designed to help you set aside money for retirement. Because an annuity is a long-term investment, stiff penalties are often associated with closing out an annuity early, especially if you want to withdraw the entire amount available in your contract. Taxes will be due when you close out your annuity; the amount due depends on whether you created the annuity with qualified or non-qualified funds.
If the annuity you are closing out is a qualified annuity, that means that you used "pre-tax" dollars to fund it. A qualified annuity would be a traditional IRA or from an employer-sponsored retirement plan. Since you haven't paid taxes on any of these funds, the entire amount of the annuity would be taxed and added to your ordinary income for the year in which you close out the annuity.
A non-qualified annuity is funded with money you've already paid taxes on. Since you've already paid taxes on the premium you originally invested, only the earnings on these funds have been accumulating on a tax-deferred basis. As a result, when you close out a non-qualified annuity, the only taxable income would be earnings on the premium. For example, if you deposited $100,000 into an annuity that was worth $125,000 when you closed it out, only $25,000 would be considered taxable income.
Surrender Charges and Penalties
Most annuity contracts have a period of time called a surrender period, which can last for several years. During the surrender period, any amount that you withdraw over the amount permitted to be withdrawn penalty-free (usually 10 percent per year) is subject to a surrender charge. Surrender charges decrease over time and are eventually eliminated; if you've held your annuity contract for several years, the surrender charge may be nominal. If you close out your annuity before age 59 1/2, the IRS will assess an additional 10 percent penalty on the entire amount withdrawn. This penalty is assessed for both qualified and non-qualified annuities. Some annuity carriers will waive the surrender charges if you need the money for specific circumstances, like long-term care or a terminal illness.
Closing out your annuity could move you into a higher tax bracket. If you are closing out a qualified annuity, the annuity carrier may withhold an additional 20 percent and remit that directly to the IRS to pay the taxes due on the distribution, but that may not be enough to cover your tax liability, especially if you have other income sources. If you are drawing Social Security at the time you close out your annuity, the annuity distribution could affect the amount of your Social Security that is considered taxable income as well. If you don't need the entire balance of your annuity right away, you may be able to annuitize the contract and convert it to a source of income without incurring surrender charges or a large tax bill.
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