Yes, you can cash out an annuity, but doing so often triggers significant financial penalties, taxes, and surrender charges that can eat away at your money. According to the Insurance Information Institute, annuity surrender charges alone can range from 1% to 10% of your account value, depending on when you withdraw money and how long your contract has been in place.
What You’ll Learn
🎯 The real cost of cashing out: Why surrender charges, income taxes, and early withdrawal penalties can reduce your payout by 20% to 40%
💰 When it makes sense: Specific situations where cashing out an annuity might be your best option despite the penalties
⚖️ Your withdrawal options: The difference between lump sum withdrawals, 1035 exchanges, and structured settlements
🔍 Common mistakes that cost money: Why people lose thousands by cashing out at the wrong time or using the wrong method
📋 State and federal rules: How IRS regulations and insurance laws control what you can and cannot do with your annuity
Understanding What an Annuity Is
An annuity is a contract with an insurance company where you give them money upfront (or over time), and they promise to pay you back either immediately or in the future. The Securities and Exchange Commission defines annuities as long-term investment contracts designed to provide income during retirement. Most people buy annuities because they want guaranteed income they cannot outlive, which makes them different from regular investments like stocks or bonds.
There are different types of annuities, and which one you own affects whether you can cash out and how much money you will lose. An immediate annuity starts paying you money right away—sometimes within 30 days of purchase. A deferred annuity waits to pay you until a future date you choose, which could be 5 years away or 20 years away.
The Surrender Charge: Your Biggest Cost When Cashing Out
When you sign an annuity contract, the insurance company builds in something called a surrender charge. This is a penalty they take from your money if you want all of it back before the contract says you can have it. According to research from the National Association for Insurance Commissioners, surrender charges typically last between 5 and 10 years after you buy the annuity, and they usually decrease each year.
| Withdrawal Scenario | Surrender Charge Impact |
|---|---|
| Year 1 of contract | 7% to 10% of withdrawal amount |
| Year 3 of contract | 5% to 7% of withdrawal amount |
| Year 7 of contract | 1% to 3% of withdrawal amount |
| After surrender period ends | 0% surrender charge (but other taxes still apply) |
Here is why insurance companies charge this penalty: they count on keeping your money invested for a long time so they can make profits from it. When you take money out early, they lose that future profit, so they charge you to make up for what they lose. The longer your contract has been active, the lower the surrender charge becomes, because they have already made some of their expected profit.
Federal Tax Rules: The IRS Penalty on Early Withdrawals
Beyond surrender charges, the IRS adds its own penalty if you withdraw money from an annuity before you reach age 59½. According to IRS Publication 575 on Annuity Distributions, you will pay a 10% early withdrawal penalty on top of regular income taxes on the money you take out. This is called the premature distribution penalty, and it applies to non-qualified annuities (annuities bought with after-tax money) and qualified annuities (annuities bought through retirement plans like IRAs or 401(k)s).
The income tax itself depends on whether you bought your annuity with pre-tax money or after-tax money. If you bought it with after-tax money (a non-qualified annuity), you only pay income tax on the earnings you made, not on the money you originally put in. If you bought it through a retirement account (a qualified annuity), you pay income tax on the entire amount you withdraw because you never paid taxes on it when you first invested it.
| Type of Annuity | Tax Treatment When You Cash Out |
|---|---|
| Non-qualified annuity | Tax on earnings only + 10% penalty if under 59½ |
| Qualified annuity (IRA/401k) | Tax on full withdrawal + 10% penalty if under 59½ |
| After surrender period ends | Still owe income tax, but 10% penalty goes away at 59½ |
When Cashing Out Makes Financial Sense
Not every situation calls for cashing out your annuity, but certain scenarios make it the right choice despite the penalties. The key is comparing what you will keep after all penalties versus what staying in the contract would give you.
Scenario 1: The Immediate Financial Emergency
Sarah is 52 years old and bought a deferred annuity 3 years ago with $100,000. She loses her job and needs money for her mortgage, medical bills, and living expenses. Her annuity surrender charge is currently 5%, and she will owe a 10% IRS penalty for being under 59½. Here is what happens if she cashes out:
| Financial Impact | Amount |
|---|---|
| Original annuity value | $100,000 |
| Surrender charge (5%) | -$5,000 |
| Amount left for IRS | $95,000 |
| 10% IRS penalty (under 59½) | -$9,500 |
| Income tax on gains (assume $20,000 gain, 24% tax bracket) | -$4,800 |
| Cash Sarah receives | $75,700 |
Sarah loses $24,300, which hurts. However, if she cannot pay her mortgage and faces foreclosure or bankruptcy, cashing out might be better than losing her home. The financial emergency creates a situation where the penalty cost is worth the benefit of having immediate access to cash.
Scenario 2: A Bad Annuity with High Fees
Michael bought a variable annuity 8 years ago that has extremely high fees—2% per year in charges. He later learns that many variable annuities charge excessive fees that eat away at his returns. His contract still has 2 years left before the surrender period ends. Michael calculates that he is paying $4,000 per year in fees on his $200,000 annuity.
Even though Michael will pay a 3% surrender charge ($6,000) if he cashes out now, he avoids 2 years of $4,000-per-year fees ($8,000). His total penalty cost is $6,000, but his fee savings are $8,000, plus he eliminates future years of high fees. In this case, leaving the bad annuity makes mathematical sense.
Scenario 3: Access to Money Under Exception Rules
Jessica is 45 years old and has a deferred annuity. She does not have access to the money without penalties—unless she qualifies for an exception. According to IRS Rule 72(t) on Substantially Equal Periodic Payments, she can withdraw money without the 10% penalty if she commits to taking equal payments based on her life expectancy. She does not face the penalty, though she still owes income tax and surrender charges.
Jessica qualifies for this rule and starts taking $8,000 per year from her annuity. She avoids the 10% penalty, but she still pays income tax and surrender charges on what she withdraws. This is one of the few situations where the IRS lets you avoid the penalty for early withdrawal.
The Surrender Period: When Your Money Gets “Free”
Every annuity contract has what is called a surrender period—a set number of years during which you face surrender charges if you take money out. The Financial Industry Regulatory Authority explains that surrender periods typically last 5 to 10 years, though some annuities have longer or shorter periods.
As time passes and you move closer to the end of the surrender period, your surrender charge decreases. Year 1 might have a 10% charge, Year 2 a 9% charge, Year 3 an 8% charge, and so on. After the surrender period ends completely, you can withdraw money without any surrender charge from the insurance company—though you still owe income taxes to the IRS.
| Year in Contract | Surrender Charge | Can You Withdraw Without Penalty? |
|---|---|---|
| Year 1 | 10% | No—full penalty applies |
| Year 4 | 7% | No—reduced penalty applies |
| Year 6 | 5% | No—reduced penalty applies |
| Year 10 (end of period) | 0% | Yes—no surrender charge |
Waiting for the surrender period to end often makes more financial sense than cashing out early. If you are 2 years away from the end of the surrender period, you might want to wait those 2 years instead of cashing out now and losing the surrender charge. The surrender period is a major reason why financial advisors suggest only buying annuities if you truly will not need the money for many years.
The 1035 Exchange: A Tax-Smart Way Out
If you own an annuity you dislike but want to move your money into a different annuity, you have an option called a 1035 exchange. Named after IRS Section 1035, this rule lets you move money from one annuity to another without cashing out. You avoid the income tax on the move, and you avoid the 10% early withdrawal penalty—though you still face surrender charges from your old contract.
A 1035 exchange works like this: your old annuity company transfers your money directly to a new annuity company. The IRS does not count this as a distribution, so you do not owe taxes on it. However, your old insurance company still charges you a surrender charge for leaving early. You also restart the surrender period with your new annuity, meaning you sign up for another 5 to 10 years of surrender charges with the new company.
| Cashing Out vs. 1035 Exchange | Cashing Out | 1035 Exchange |
|---|---|---|
| Surrender charge from old annuity | Yes—you pay it | Yes—you pay it |
| Federal income tax | Yes—on gains | No—deferred |
| 10% IRS penalty (under 59½) | Yes—applies | No—avoided |
| New surrender period starts | N/A | Yes—5 to 10 years |
A 1035 exchange makes sense when you want to get out of a bad annuity but want to stay in the annuity market. You avoid the 10% federal penalty and income taxes, but you still lose money to the surrender charge and commit to another long contract. Make sure the new annuity has better features and lower fees before making the switch, or you are just trading one bad deal for another bad deal.
Qualified Annuities vs. Non-Qualified Annuities: Different Rules Apply
The tax rules change depending on whether your annuity is qualified (bought with retirement money) or non-qualified (bought with regular money). Understanding which type you own changes the entire calculation of what you will owe.
A qualified annuity is bought with pre-tax money through a retirement account like an IRA, 401(k), 403(b), or government 457 plan. According to IRS Publication 590-B on Distributions, when you withdraw from a qualified annuity, the entire amount counts as ordinary income subject to taxes at your current tax bracket rate. If you are in the 32% tax bracket, you owe 32% in income tax on whatever you withdraw, plus the 10% early withdrawal penalty if you are under 59½.
A non-qualified annuity is bought with after-tax money you set aside from your own savings. Only the earnings on your money are taxed—not the original money you put in, because you already paid taxes on that money. This makes non-qualified annuities more favorable from a tax perspective when you withdraw early, because you pay less total tax.
| Annuity Type | Where Money Came From | Tax on Withdrawal |
|---|---|---|
| Qualified | Pre-tax retirement account | Full amount taxed as ordinary income |
| Non-qualified | After-tax personal savings | Only earnings taxed as ordinary income |
Structured Settlement Annuities: Special Rules for Lawsuit Money
If you received an annuity as part of a lawsuit settlement (for personal injury, workers’ compensation, or a similar case), you own a structured settlement annuity. These have different rules than regular annuities because they exist to protect people who won money in court.
Structured settlement annuities are usually set up so you cannot cash them out before a certain date, even if you want to. The court or the company being sued does not want to give you a lump sum of money upfront, so they buy an annuity that pays you over 20 or 30 years. If you want your money early, you must go through a special legal process and get court approval.
According to the National Structured Settlements Trade Association, if a court approves your early withdrawal, you typically must pay a discount fee of 10% to 45% to whoever buys your future payments. If your settlement is supposed to pay you $50,000 over the next 10 years and you want all that money now, a buyer might only give you $30,000 to $40,000 because they are buying your future payments at a discount. This is very different from a regular annuity, where you might pay 5% to 10% in penalties—structured settlement early withdrawals are much more expensive.
Common Mistakes That Cost Money
Mistake 1: Cashing Out Because You Are Bored or Impatient
People sometimes cash out annuities simply because the payments are smaller than they expected, or they want access to all their money at once. They do not have an emergency or a good financial reason—they just get tired of waiting. This is one of the costliest mistakes because you lose 20% to 40% of your money for no reason other than impatience.
Mistake 2: Not Understanding Your Surrender Period
Many annuity owners do not know when their surrender period ends. They cash out in Year 4, paying a 6% surrender charge, when waiting just 1 more year would have eliminated that charge completely. Always check your contract to find the exact date your surrender period ends before you withdraw money.
Mistake 3: Cashing Out Without Checking for Exceptions
The IRS has several exceptions to the 10% penalty, including Rule 72(t), Roth conversions, and disability. People often cash out and pay the full 10% penalty without realizing they might qualify for an exception that would save them thousands of dollars.
Mistake 4: Not Comparing Withdrawal Methods
Some people rush to take a lump sum without comparing it to other options like a 1035 exchange or systematic withdrawals. A lump sum triggers all penalties and taxes at once, while spreading withdrawals across multiple years might lower your tax bracket and reduce your total tax bill.
Mistake 5: Moving Money Into Another Bad Annuity
People use a 1035 exchange to escape a high-fee annuity, but then they buy another high-fee annuity from a different company. They restart the surrender period and commit another 5 to 10 years to an expensive product. Always compare the new annuity’s fees, features, and terms before moving your money.
Mistake 6: Ignoring State Insurance Laws
Each state has different rules about how long a surrender period can last, what fees are allowed, and what disclosures the insurance company must give you. Some states have stronger protections for consumers than others. People sometimes do not know their state’s rules and miss protections or deadlines available to them.
Do’s and Don’ts When Considering a Cash-Out
DO: Get a detailed written breakdown from your insurance company showing your current surrender charge, the exact date your surrender period ends, and your tax basis (how much of your money is earnings vs. original contributions).
DO: Meet with a tax professional before cashing out to understand your full tax bill, because the insurance company only calculates surrender charges, not federal or state income taxes.
DO: Compare your options: lump sum withdrawal, 1035 exchange, systematic withdrawals, or waiting until the surrender period ends.
DO: Consider whether you qualify for any IRS exceptions to the 10% penalty, which could save you thousands of dollars.
DO: Review your annuity contract and the insurance company’s website to understand your specific surrender schedule, because different annuities have different charge structures.
DON’T: Cash out an annuity during a market downturn just because you are worried about losses, unless you have a true financial emergency.
DON’T: Assume that after the surrender period ends, there are no more costs or penalties—you still owe income taxes on your earnings.
DON’T: Use a 1035 exchange to move money to another annuity without carefully comparing the new annuity’s fees, features, and terms.
DON’T: Withdraw from a structured settlement annuity without getting court approval, because doing so can create legal problems.
DON’T: Forget about state-level taxes on annuity withdrawals—many states add additional income tax on top of federal taxes.
Pros and Cons of Cashing Out Your Annuity
| Pros | Cons |
|---|---|
| Immediate access to your money for emergencies or opportunities | Surrender charges eat 1% to 10% of your withdrawal amount |
| Escape a high-fee annuity that is costing you money each year | 10% IRS penalty if under 59½ (with rare exceptions) |
| Avoid being locked in if your personal situation changes dramatically | Full income tax on earnings (and potentially on entire amount if qualified) |
| May qualify for exceptions to the 10% penalty if circumstances fit | Restart of surrender period if you use 1035 exchange for new annuity |
| Flexibility to invest the money elsewhere if you believe you can earn better returns | Loss of guaranteed income stream that you cannot outlive |
| Ability to leave money to heirs immediately instead of through annuity payments | May push you into a higher tax bracket, affecting other deductions |
Real Examples: The Numbers Behind Cashing Out
Example 1: The Early Emergency Withdrawal
Thomas bought a $150,000 deferred annuity 2 years ago. He is 56 years old. His car breaks down, his furnace needs replacing, and he faces $25,000 in unexpected costs. His annuity contract says the surrender charge is 8% in Year 2. His $25,000 withdrawal breaks down like this:
- Original withdrawal request: $25,000
- Surrender charge at 8%: -$2,000
- Taxable gain in the $25,000 (assume $5,000): taxed at 24% = -$1,200
- 10% IRS penalty on the gain: -$500
- Money Thomas receives: $21,300
Thomas loses $3,700 of his $25,000 request—about 15% of what he tried to withdraw. The emergency was worth the cost, because he avoided a car accident and could heat his home through winter.
Example 2: The Timing Question
Rebecca owns a $200,000 annuity that is in Year 9 of a 10-year surrender period. The surrender charge is 1%. She is 58 years old and wonders if she should cash out now or wait 1 year until the surrender period ends.
Option A: Cash out now (Year 9)
- Surrender charge at 1%: -$2,000
- 10% IRS penalty on gains (assume $40,000 gain): -$4,000
- Income tax on gains at 24%: -$9,600
- Total penalties and taxes: -$15,600
- Money received: $184,400
Option B: Wait 1 year (Year 10)
- Surrender charge: $0 (period ends)
- 10% IRS penalty on gains: -$4,000 (still applies—she is still under 59½)
- Income tax on gains at 24%: -$9,600
- Total penalties and taxes: -$13,600
- Money received: $186,400
By waiting just 1 year, Rebecca keeps an extra $2,000 that would have gone to the surrender charge. The 10% penalty stays the same because she is still under 59½, but eliminating the surrender charge saves her money.
Example 3: The 1035 Exchange Decision
David owns a variable annuity with a $300,000 value. His current annuity charges 2.5% per year in fees, and he is frustrated. He finds a new annuity with 0.75% in fees. He is 50 years old, and his surrender period does not end for 4 more years. The current surrender charge is 4%.
Cashing out completely:
- Surrender charge at 4%: -$12,000
- 10% IRS penalty on gains (assume $60,000 gain): -$6,000
- Income tax on gains at 24%: -$14,400
- Total cost: -$32,400
- Money received: $267,600
Using a 1035 exchange:
- Surrender charge at 4%: -$12,000
- 10% IRS penalty: -$0 (avoided through 1035)
- Income tax: -$0 (deferred through 1035)
- Money transferred to new annuity: $288,000
- New surrender period starts: 5 to 10 years
David keeps an extra $20,400 by using the 1035 exchange, and he avoids $20,400 in immediate taxes. However, he commits to another surrender period with the new company. If the new annuity has genuinely better terms and lower fees, this trade-off makes sense.
Special Situations: Disability, Death, and Exceptions
The IRS recognizes that not everyone who needs money before age 59½ is being irresponsible. IRS Publication 575 lists exceptions to the 10% early withdrawal penalty, including disability and certain medical expenses.
If you become disabled and cannot work, you can withdraw from your annuity without the 10% penalty. The IRS defines disability narrowly—you must have a condition that prevents you from working and is expected to last at least 12 months or result in death. You still owe income tax on your earnings, and you still pay any applicable surrender charge, but the 10% penalty goes away.
If you face qualified medical expenses that exceed a certain percentage of your income, you may be able to withdraw money without the 10% penalty. These are major medical costs for yourself or your family, not routine doctor visits. Again, you owe income tax and surrender charges, just not the 10% penalty.
If you die, your heirs can take the money from your annuity without facing the 10% penalty. They still owe income tax on the gains, but the early withdrawal penalty does not apply because you are no longer “early withdrawing”—you have passed away.
State-Specific Rules and Protections
While annuity rules are mostly controlled by federal law and IRS rules, states add their own protections. Some states limit how long a surrender period can last, require insurance companies to clearly disclose fees, or give buyers a cooling-off period to cancel without penalty.
According to state insurance commissioner guidelines, most states require a 10-day or 30-day period after you buy an annuity during which you can cancel without any surrender charge. This gives you time to read the contract carefully and back out if you realize it is not right for you. However, this only applies immediately after purchase—it does not protect you later if you change your mind.
Some states also regulate whether insurance companies can charge surrender fees that last longer than 10 years. A few states have stronger consumer protections than others, and if you live in a consumer-friendly state, you might have more rights than someone living elsewhere. Check your state insurance commissioner’s website to learn about your specific state’s rules.
How Insurance Company Ratings Affect Your Risk
When you buy an annuity, you are counting on the insurance company to stay in business and pay you for decades. If the company fails, your payments stop, and you might lose money. This is why the financial strength of your insurance company matters.
Companies like A.M. Best rate insurance company strength, and ratings range from A++ (excellent) down to C (weak). If you buy an annuity from a company rated A or better, the risk is very low. If a company is rated below B, the risk of failure is much higher. Before cashing out your annuity, consider whether you are abandoning a strong, reliable company for cash in hand—if your annuity company is financially strong, staying in the annuity might be safer than investing the money elsewhere.
The National Organization of Life and Health Insurance Guaranty Associations provides some protection if an insurance company fails, but coverage is typically limited to $250,000 per person per company. If your annuity is worth more than that, you have additional risk if you are counting on the insurance company’s financial security.
The Tax Bracket Effect: Why Timing Matters
When you cash out an annuity, the money you withdraw is treated as ordinary income and gets added to all your other income for the year. If you withdraw a large amount, you might push yourself into a higher tax bracket, meaning you pay a higher percentage in taxes not just on the annuity money but on your other income too.
For example, if you earn $60,000 from work and withdraw $50,000 from your annuity, the IRS treats you as if you earned $110,000 that year. This might push you from the 22% tax bracket to the 24% tax bracket, and you might lose tax deductions that phase out at higher incomes. Your total tax bill could be significantly higher than if you simply took $25,000 one year and $25,000 the next year.
This is one reason to talk to a tax professional before cashing out. Spreading your withdrawal across multiple years, waiting until a lower-income year, or timing it around retirement can all save you thousands in taxes. Strategic timing of your withdrawal is often overlooked but extremely valuable.
Who Should NOT Cash Out Their Annuity
Certain people should strongly avoid cashing out their annuities, even if they think they want to. If you bought an annuity specifically because you wanted guaranteed income you cannot outlive, cashing it out defeats the entire purpose. Your annuity is basically insurance against living too long and running out of money—by cashing out, you are removing that insurance.
If you are in a stable financial situation and do not have an emergency or compelling reason to access the money, waiting is almost always smarter than cashing out. The penalties and taxes are too steep to justify cashing out just because you are impatient or bored with your investment.
If you are close to the end of your surrender period (within 1 to 3 years), waiting usually makes much more financial sense than cashing out now. The surrender charge will drop significantly or disappear, and that alone can save you thousands of dollars.
If you qualify for an exception to the 10% penalty, such as disability or medical hardship, exploring that option first is smarter than taking a full cash withdrawal. Exceptions save you the 10% penalty while keeping your annuity intact.
Key Takeaways: The Bottom Line on Cashing Out
You can cash out an annuity, but the financial cost is usually steep due to surrender charges, income taxes, and IRS penalties. Cashing out makes sense only when you face a true financial emergency, can prove you will save money compared to staying in the annuity, or qualify for an IRS exception that reduces your tax burden. Before you decide, get written details from your insurance company about your surrender charge, talk to a tax professional about your specific tax situation, and compare all your options including 1035 exchanges and systematic withdrawals. Understanding the true cost of cashing out—not just the surrender charge, but the full tax picture—is essential to making a choice you will not regret later.
FAQs
Can I cash out my annuity before the surrender period ends?
Yes. You can always request a full withdrawal, but you will pay the surrender charge set in your contract, plus income tax and potentially a 10% IRS penalty if you are under 59½.
How much does it cost to cash out an annuity?
Cost varies. Surrender charges range from 1% to 10%, income tax applies to earnings, and a 10% early withdrawal penalty may apply if you are under 59½. Total costs often reach 20% to 40% of your withdrawal amount.
What happens if I cash out an annuity before age 59½?
You pay a 10% penalty. The IRS adds a 10% early withdrawal penalty to your income tax bill, plus the surrender charge from your insurance company and regular income taxes on gains.
Is a 1035 exchange better than cashing out?
Usually yes. A 1035 exchange avoids the 10% IRS penalty and income taxes but still charges a surrender fee and starts a new surrender period. Compare the new annuity’s quality before switching.
Can I avoid the 10% penalty?
Maybe. Exceptions include disability, medical hardship, IRS Rule 72(t), and other specific circumstances. Talk to a tax professional about whether you qualify.
What if I die? Can my heirs cash out the annuity?
Yes. Your heirs can withdraw the money without facing the 10% early withdrawal penalty, but they still owe income tax on the earnings portion of the annuity.
How long is a typical surrender period?
Five to ten years. Most annuity contracts have surrender periods between 5 and 10 years, though some are shorter or longer. The surrender charge decreases each year.
Do I still owe taxes after the surrender period ends?
Yes. When the surrender period ends, you no longer pay the surrender charge, but you still owe income tax on your earnings when you withdraw money. The 10% IRS penalty also still applies if you are under 59½.
What is the difference between cashing out and taking withdrawals?
Timing and tax brackets matter. A lump sum cash-out triggers all penalties and taxes at once, while scheduled withdrawals spread the tax bill across multiple years and might keep you in a lower tax bracket.
Should I cash out if I am unhappy with my annuity?
Not usually. Calculate whether you will save money long-term by switching. If you are close to the end of your surrender period or paying very high fees, maybe. Otherwise, waiting often makes more sense.
Related reading
- How to Make a Retirement Annuity Actually Work (w/Examples) + FAQs
- Can I Withdraw From My Retirement Annuity? (w/Examples) + FAQs
- Can I Withdraw My Fund Value in Allianz? (w/Examples) + FAQs
- Can You Buy an Annuity With Cash? (w/Examples) + FAQs
- Can You Withdraw From an Annuity? (w/Examples) + FAQs
- Does a 1035 Exchange Avoid the Annuity Early Withdrawal Penalty? (w/Examples) + FAQs