When you terminate an annuity, you get your remaining money back, but you may owe taxes and surrender charges

Ending an annuity contract before the stated maturity date means the insurance company returns your remaining balance to you, minus any surrender charges that the contract allows them to keep. You will also owe income tax on the earnings portion of that withdrawal in the year you take it out. If you are under 59½, the IRS adds a 10 percent early withdrawal penalty on top of the income tax, unless a narrow set of exceptions applies to your situation.

The exact amount you receive depends on three things: how much you originally put in, how much the annuity has earned, and how many years remain on the surrender charge schedule. A contract that charges 7 percent in year one might charge 6 percent in year two, stepping down by 1 percent each year until it reaches zero. If you are in year three of a seven-year schedule, you lose 5 percent of your account value to the insurance company before taxes are calculated.

Key Takeaways

  • Surrender charges are set by your contract and typically decline each year, so the cost of terminating drops as time passes.
  • You owe federal income tax on all earnings withdrawn, plus a 10 percent IRS penalty if you are under 59½, with limited exceptions for disability or medical expenses.
  • The surrender charge applies to your account value before taxes, so a 5 percent charge on a $100,000 account costs $5,000 regardless of your tax bracket.
  • Some contracts allow you to withdraw a small amount each year without surrender charges, which may be a cheaper way to access money than a full termination.
  • State insurance regulators set a maximum surrender charge period, which varies by state but is typically 10 years or less.

How surrender charges work and when they explore

A surrender charge is a fee the insurance company keeps when you withdraw more than your contract allows penalty-free. It is written into your annuity contract as a percentage of your account value and a schedule showing how many years it applies. A typical schedule might read: 7 percent in years 1–2, 6 percent in years 3–4, 5 percent in years 5–6, and 0 percent in year 7 and beyond.

The charge applies to your full account balance on the day you request the withdrawal, not just the amount you are taking out. If your contract says you can withdraw 10 percent per year without penalty and you withdraw 15 percent, the surrender charge applies to the entire 15 percent, not just the extra 5 percent. This is why knowing your contract terms matters before you call the insurance company.

Once the surrender charge period ends, you can withdraw your full balance without that fee, though you will still owe income tax on the earnings. Some contracts also include a free withdrawal amount each year—often 10 percent of your account value—that you can take without triggering the surrender charge. Using this annual allowance is one way to reduce your account slowly without paying the full penalty.

Tax consequences of early termination

When you terminate an annuity, the IRS treats the withdrawal as income in the year you receive it. The earnings portion—everything above what you originally contributed—is taxed at your ordinary income tax rate, which could be 10 percent, 12 percent, 22 percent, or higher depending on your total income that year. The original amount you put in, called your cost basis, comes out tax-free because you already paid taxes on that money when you earned it.

If you are under 59½, the IRS adds a 10 percent early withdrawal penalty on the earnings portion only, not on your cost basis. So on a $100,000 account with $30,000 in earnings, the penalty applies to that $30,000, costing you $3,000 in addition to income tax. This penalty exists to discourage early withdrawals from retirement savings vehicles.

The IRS does allow exceptions to the 10 percent penalty in specific situations: if you are disabled, if you use the money for unreimbursed medical expenses above 7.5 percent of your adjusted gross income, or if you take substantially equal periodic payments over your life expectancy using IRS tables. These exceptions are narrow and have strict rules, so you should discuss your situation with a tax professional before withdrawing.

Calculating what you actually receive

The order of calculation matters because surrender charges reduce your account before taxes are figured. Here is the real sequence: your account value on the termination date, minus the surrender charge, equals your taxable distribution. You then owe income tax and possibly the 10 percent penalty on the earnings portion of that reduced amount.

Example: You have a $100,000 annuity with $25,000 in earnings and $75,000 in cost basis. You are 55 years old and in year three of a seven-year surrender charge schedule that charges 5 percent. The insurance company subtracts 5 percent of $100,000 ($5,000) first, leaving $95,000. You owe income tax on the $25,000 earnings portion at your tax rate—say 22 percent, which is $5,500. You also owe the 10 percent early withdrawal penalty on the $25,000 earnings, which is $2,500. Your net check is $95,000 minus $5,500 minus $2,500, or $87,000. The insurance company sends you a 1099-R form reporting the $95,000 distribution so you can file your taxes correctly.

Your actual tax bill depends on your total income that year. If you have other income, the annuity withdrawal might push you into a higher tax bracket. A tax professional can estimate your liability before you request the withdrawal, which helps you decide whether to wait until the surrender charge drops or to take the hit now.

Alternatives to full termination

You do not have to end the entire contract to access your money. Most annuities allow you to take a free withdrawal each year, typically 10 percent of your account value, without any surrender charge. If you need $10,000 and your account is $100,000, you can withdraw that $10,000 free of the surrender charge and leave the rest growing. You still owe income tax on the earnings portion of that withdrawal, but you avoid the surrender fee.

Another option is to annuitize your contract, which means converting your account balance into a stream of monthly or annual payments for life or a set number of years. Once you annuitize, you cannot change your mind, but you lock in a may provide income and may reduce your tax burden by spreading the earnings over multiple years instead of taking a lump sum. Some people use annuitization as a way to access their money while avoiding the surrender charge entirely.

If you need money urgently and the surrender charge is steep, you might also borrow against your annuity through a policy loan, though not all contracts offer this. A loan does not trigger the surrender charge or when ready tax, but you pay interest and the loan balance reduces your death benefit. This is a temporary solution, not a permanent exit from the contract.

How to request a termination and what to expect

Contact your insurance company directly—the phone number is on your contract or statement—and ask to speak with a representative about surrendering your annuity. They will ask for your contract number, date of birth, and the reason for the withdrawal. You do not have to explain your reason, but they may ask anyway. They will calculate your surrender charge, your net proceeds, and the tax reporting amount, then send you a written estimate before processing the request.

The insurance company will send you a form to sign, usually a surrender request or termination form. Read it carefully because signing it is your formal instruction to end the contract. Once you sign and return it, the company typically processes the withdrawal within 5 to 10 business days, though some contracts allow longer. The funds are usually sent by check or electronic transfer to your bank account.

You will receive a Form 1099-R from the insurance company by January 31 of the following year, showing the total amount withdrawn and the taxable portion. Use this form when you file your tax return. If the company makes a mistake on the 1099-R—for example, if it reports the wrong amount or fails to show your cost basis—contact them when ready to request a corrected form before you file.

State protections and surrender charge limits

Your state's insurance commissioner sets rules about how long an insurance company can charge surrender fees on annuities. Most states cap the surrender charge period at 10 years, though some allow longer periods for certain types of annuities. A few states require that surrender charges decline by at least 1 percent per year, so a 10-year schedule cannot charge 10 percent in every year.

If your contract includes a surrender charge schedule that violates your state's rules, you may have grounds to dispute it. Contact your state insurance commissioner's office if you believe your contract is unfair or if the insurance company is charging you a surrender fee that exceeds what state law allows. The commissioner's office can investigate and sometimes force the company to refund improper charges.

Frequently Asked Questions

Can I avoid the surrender charge by waiting until I turn 59½?

No. The surrender charge is based on how long ago you bought the annuity, not your age. If you are in year three of a seven-year surrender charge schedule, you will pay the year-three charge whether you are 50 or 70. However, once you turn 59½, you will no longer owe the 10 percent IRS early withdrawal penalty on the earnings, which saves you money if you do terminate.

What if I need the money for a medical emergency?

You still owe the surrender charge to the insurance company. The IRS may waive its 10 percent penalty if you can show the withdrawal was for unreimbursed medical expenses above 7.5 percent of your adjusted gross income, but that is a separate issue from the surrender charge. The insurance company's fee applies regardless of why you are withdrawing.

Do I have to pay the surrender charge if I move the annuity to a different insurance company?

Yes, unless you use a 1035 exchange, which is a tax-free transfer of an annuity to another company. A 1035 exchange avoids the surrender charge and the when ready tax bill, but you start a new surrender charge schedule with the new company. Discuss this option with the new insurance company before you request the transfer.

What happens to my annuity if I die before I terminate it?

Your beneficiary receives the account balance, minus any surrender charges if they choose to withdraw it when ready. If the contract includes a death benefit that guarantees a minimum payout, your beneficiary gets the higher of the account value or the may provide amount. The surrender charge still applies to any withdrawal, but your beneficiary can also choose to keep the annuity in force and continue receiving payments.

Can the insurance company refuse to let me terminate my annuity?

No. You have the right to terminate any annuity contract you own. The insurance company cannot refuse, but they can charge the surrender fee that your contract allows. If they refuse to process your termination request, contact your state insurance commissioner's office.