Annuity surrender charges and free withdrawals

A surrender charge is a fee a deferred annuity takes if you withdraw more than the contract allows, or cancel it, during a set number of years after you buy. The charge is a percentage of the amount withdrawn, usually highest in year one and falling to zero by the end of the surrender period. Most contracts let you take out a limited amount each year without a charge, so the real cost depends on how much you need, and when.

Why surrender charges exist

When an insurer takes your money, it invests it for the long term, often in bonds, and typically pays the agent's commission up front. If you leave early, it may have to sell investments at a loss and has not yet earned back the commission. The surrender charge protects the insurer from that and, in a fixed contract, helps it offer a higher rate than it could if everyone could leave at will. FINRA notes that variable annuities can have surrender periods of eight years or more and that annuities are complex and can be costly.

Surrender charges apply to deferred annuities: fixed annuities: how they work, what they cost, who they suit, fixed indexed annuities: caps, participation rates and trade-offs, variable annuities: how they work, what they cost, who they suit, RILAs and MYGAs. A single-premium immediate annuity has none, because you cannot get the money back once you buy. (Life insurance has similar charges; see life insurance surrender charges explained.)

How a typical schedule works

Schedules are set by the contract and vary widely. The table below is a hypothetical seven-year schedule, not any company's actual terms.

Say a hypothetical owner has $100,000 in year three and withdraws all of it, with a free-withdrawal allowance of 10% of the value. The first $10,000 is free, and the remaining $90,000 carries a 6% charge, or $5,400. The owner would receive $94,600 before taxes. Some contracts calculate the charge on the original premium rather than the current value, and a few use a different clock for each premium paid, so read the schedule.

The free-withdrawal provision

Many contracts allow a yearly free withdrawal without a surrender charge, often a percentage of the account value or of premiums, and often tied to the account value at a given date. Contracts differ, and the allowance can be non-cumulative, meaning you lose it if you do not use it. Other common features:

• Required minimum distributions. Many insurers waive charges on RMDs from an IRA annuity.
• Waivers. Some contracts waive the charge for death, nursing home confinement or terminal illness. They are not universal, and they have conditions. Confirm which ones your contract includes.
• Interest-only withdrawals. Some contracts let you take earnings only.

Surrender charges are separate from taxes. A withdrawal may be taxable and, before age 59 1/2, may carry a 10% additional tax, as in how annuities are taxed.

Market value adjustments

Some fixed contracts, including many multi-year guaranteed ones, also apply a market value adjustment (MVA). If interest rates have risen since you bought, the MVA reduces what you receive on early withdrawal; if rates have fallen, it can increase it. It stacks on top of or replaces the surrender charge, depending on the contract. The contract should state the formula and whether an MVA has a floor, so that your principal is not reduced below a guaranteed amount.

Who feels surrender charges most

Surrender charges matter little to an owner who is sure the money will stay put for the whole period, such as a retiree who set aside funds for income starting in a decade. They matter a great deal to someone who may need a lump sum for medical bills, a move or a family emergency, and to older buyers whose health may change inside the schedule. The older you are at purchase, the more a long schedule deserves scrutiny. Some states set limits for senior buyers, such as longer free-look periods, so check your state insurance department's rules rather than assuming the contract is the only limit. If you feel misled about surrender terms at the time of sale, you can file a complaint with the department; see best interest rules for annuity sales for the standards sellers are expected to meet.

What to check before you buy

1. Find the surrender schedule and its length. A longer schedule is not automatically bad, but it is a longer commitment.
2. Ask what the free-withdrawal amount is, and whether it carries over.
3. Check whether there is an MVA and how it works.
4. Look for waivers you may need, such as nursing home or terminal illness.
5. Compare the charge schedule with the rate or features you get in exchange. A bonus annuity credit often comes with a longer or steeper schedule, and the credit can be recaptured.
6. In a state with a free look period, note the days you have to cancel with no surrender charge.

If you are already in a contract

• Wait it out. If the charge falls to zero in a year or two, delaying can be cheaper than leaving.
• Take free withdrawals. Use the allowance each year to move money gradually.
• Use a 1035 exchange. A 1035 exchanges: swapping policies without tax to a new annuity avoids tax but not the old surrender charge, and a new contract starts a new surrender period. Replacement is a common source of complaints, and a salesperson earning a new commission has an incentive to recommend it. See annuity sales abuses targeting seniors.
• Compare the total cost. Add the surrender charge to the lost value of the old guarantees before judging whether the new product is better.

Key takeaways

• A surrender charge is a percentage fee on withdrawals above the free amount, usually declining to zero over several years.
• Immediate annuities have no surrender charge, but you also cannot get your money back.
• The free-withdrawal allowance, waivers and any market value adjustment matter as much as the headline schedule.
• Replacing an annuity can cost you the old surrender charge and starts a new surrender period.
• Read the contract's schedule before you buy, and do not count on money you may need inside the surrender period.