Taking annuity money before 59½: when the 10 percent tax applies

Money taken from an annuity before the owner turns 59½ can carry a 10% additional tax on top of ordinary income tax, unless an exception applies. The rule surprises many people because the annuity contract may be perfectly happy to pay the money, and the insurer may not mention the tax at all. The questions below work through how the rule operates, what the main exceptions are and what to bring to a tax professional.

The examples use invented numbers. The rules described are federal, they have details and conditions that this post cannot cover, and a tax professional should apply them to your return. The guide on how annuities are taxed gives the wider background.

The rule and what it touches

What is the 10% additional tax, and is it the same as income tax?

It is a separate charge, added on top of the regular income tax on the taxable part of a withdrawal. Under federal law, the taxable portion of a distribution from an annuity contract before age 59½ is generally subject to an additional tax equal to 10% of that portion, unless an exception applies. Think of it as a second bill: ordinary income tax at your rate, plus 10% of the same taxable amount. Many people call it a penalty, and the IRS describes it as an additional tax.

Which part of my withdrawal does it apply to?

It applies to the taxable part only, not to the return of your own after-tax premium. For a non-qualified annuity that has not been annuitized, withdrawals generally come out gains first, so the early withdrawals are usually fully taxable until the gain is used up.

Say a hypothetical owner, 52, paid $100,000 for a deferred annuity now worth $140,000, so $40,000 is gain. The owner withdraws $25,000.

• Taxable part: the smaller of $25,000 and $40,000 gain, so $25,000.
• Ordinary income tax: depends on the owner's bracket, say an illustrative 22%: $5,500.
• Additional tax: 10% × $25,000 = $2,500.
• Combined: $8,000 on a $25,000 withdrawal, or 32%.

If the owner had withdrawn after the gain was already used up, the withdrawal would come out of basis and neither tax would apply. The worksheet in taxing a non-qualified annuity withdrawal: gains come out first shows how to run this for each withdrawal.

What exactly counts as "before 59½"?

The test is the owner's age on the date of the distribution. A person who turns 59½ on September 15 is 59½ on that date. A withdrawal on September 14 is early, and one on September 15 is not. Half-year birthdays are easy to miscount, so write down the actual date: take the birth date, add 59 years and add six months.

For a contract owned jointly or by someone other than the annuitant, the question is who the tax rules treat as the "taxpayer" receiving the distribution. That is usually the owner, and the contract and tax professional can confirm.

The main exceptions

What are the main exceptions?

The federal rules list several for non-qualified annuity contracts. The ones that come up most often are:

• Age 59½ or older at the time of the distribution.
• Death. Distributions made on or after the death of the contract holder.
• Disability. Distributions attributable to the taxpayer being disabled, using the tax code's definition.
• Substantially equal periodic payments made at least annually for the life, or joint lives, of the taxpayer and a designated beneficiary.
• An immediate annuity. Payments from an annuity bought with a single premium whose payments start within a year of purchase and are substantially equal and made at least annually.
• Old money. The portion of a contract attributable to investment made before August 14, 1982.

There are others, such as certain payments from employer plans, which fall under different rules. The list of exceptions for IRAs and workplace plans is not the same as for non-qualified contracts, so do not assume an exception you read about for one applies to the other. The IRS publishes the current lists, and a tax professional can check which one fits.

How does the death exception work?

If the owner dies and a beneficiary receives the money, the distribution is generally not subject to the additional tax, even if the beneficiary is young. A 40-year-old who inherits an annuity and takes a lump sum owes ordinary income tax on the gain but not the 10%.

There is a trap for spouses. A surviving spouse who is treated as the new owner and continues the contract steps into the owner's shoes. If that spouse is under 59½ and later withdraws gain, the exception for death no longer applies to the later withdrawal, because it is a distribution to a living owner. A spouse who needs the money soon might choose a different election. The post a spouse inherits an annuity: continue it, cash out or take payments walks through these choices, and the guide on what happens to an annuity when you die explains the contract side.

What counts as disabled for this purpose?

The tax code has its own definition, which is stricter than many people expect. In general, it requires that the taxpayer be unable to engage in any substantial gainful activity because of a physical or mental condition that can be expected to result in death or to last for a long and indefinite period. A condition that merely limits your current job may not qualify, and a disability finding by another program, such as an employer plan or an insurer, does not automatically satisfy the tax test. Keep medical documentation, and ask a tax professional before relying on this exception.

How do substantially equal periodic payments work, and what can go wrong?

This exception lets an owner take money before 59½ without the 10% tax by committing to a series of payments calculated from the owner's life expectancy, made at least once a year. The IRS has described accepted calculation methods for IRAs, and a tax professional can say how they apply to a contract.

The commitment is the catch. The payments generally must continue for at least five years or until the owner reaches 59½, whichever is later. A 45-year-old who starts this arrangement is committing for roughly 14 years. If the owner changes the payments before that period ends, for any reason other than death or disability, the 10% tax can be applied retroactively to every earlier payment, plus interest. Taking an extra withdrawal in a bad year, or stopping, can be a "modification."

Say a hypothetical owner, 50, takes $12,000 a year under this exception, then stops after six years because of a family expense. The owner has not reached 59½ and has not completed the required period. The tax on the $72,000 withdrawn so far could be recalculated: 10% × $72,000 = $7,200, plus interest. The numbers are illustrative, but the structure is real, and it is why people ask for professional help before starting.

Ways to avoid it, and ways it sneaks in

Does annuitizing avoid the tax?

Often, but not automatically. Converting a contract to lifetime payments through annuitization can fit the substantially-equal-payments exception, since lifetime payments are, in form, a series of equal payments for life. But the exception only works if the arrangement meets the conditions. Annuitizing also changes the tax treatment of each payment, using the exclusion ratio. The post the exclusion ratio: how annuitized payments split into basis and gain shows how that split works, and the glossary entry on the immediate annuity explains the contract side.

An annuitization election is usually irrevocable. Do it only if the income stream suits your plan, and not only to avoid a tax.

Do surrender charges, exchanges or loans change the answer?

They interact in different ways.

• Surrender charges are separate from tax. A charge reduces the cash you receive but does not itself remove the 10% additional tax from the taxable portion. Ask the insurer how it will report a withdrawal that carries a charge.
• A 1035 exchanges: swapping policies without tax moves a contract to a new one without a taxable distribution, so the 10% tax does not apply. But if you receive cash from the exchange, that cash can be taxable, and a young owner could owe the additional tax on it.
• Loans, pledges and assignments of a non-qualified annuity are generally treated as distributions. Borrowing against the contract before 59½ can trigger the same taxes as a withdrawal.
• Gifts of a contract can trigger tax on the gain, which is a separate rule from the early-withdrawal tax and worth checking before a transfer.

Is an annuity inside an IRA treated the same way?

Not quite. An annuity held in an IRA or a workplace plan follows the rules for that account. The 10% tax for early distributions exists there too, but the exceptions list is different, and there is generally no tax-free return of basis because the money was usually pre-tax. So an exception that works for a non-qualified contract does not necessarily work for an IRA annuity, and the reverse. The guide on Should you put an annuity in an IRA? covers the IRA side, and required minimum distribution explains the rules that start later in life.

Reporting, timing and getting help

How is it reported, and does the insurer collect it?

The insurer reports a distribution on Form 1099-R, which includes a distribution code. A code that indicates an early distribution with no known exception tells the IRS that you may owe the additional tax. A code that indicates an exception applies, or a distribution after death or because of disability, tells the IRS the insurer believes an exception exists. The owner then reports the additional tax, or the exception, on the tax return, commonly using a form for additional taxes on retirement plans and annuities.

The insurer does not usually collect the 10% tax for you. Any federal withholding it takes is a separate matter, and may be less than you owe. If you take an early withdrawal, consider an estimated tax payment or a larger withholding election. If the insurer's code does not match your situation, for example if it coded a withdrawal as early when you qualify for an exception, raise it before filing.

Need, timing and next steps

Does an emergency or hardship count as an exception?

There is no general hardship exception for a non-qualified annuity. A job loss, a medical bill or a house repair does not by itself remove the additional tax. Some IRA exceptions cover specific expenses, but those belong to the IRA rules and do not carry over to a non-qualified contract. If the need is a health condition that meets the disability definition above, or the death of the owner, those exceptions can apply. Otherwise, the list in the tax code is what counts, and a surrender charge waiver in the contract, such as one for nursing home confinement, is a contract term and says nothing about tax.

Will my state add its own tax?

Some states tax annuity withdrawals as ordinary income, and a few add their own additional tax on early distributions that mirrors the federal rule. The details change, so check with your state tax agency or a preparer who handles returns in your state. A state's own additional tax may have its own exceptions, which are not always the same as the federal ones.

What if I am only a few months from 59½?

Waiting is often the simplest way to avoid the additional tax. Say the owner in the example above is 59 and four months old, and the $25,000 would cost $2,500 in additional tax if taken now. Waiting two months avoids it. Whether waiting is practical depends on need. If the money is needed now, the options are to take the least amount necessary, to ask whether another source can bridge the gap or to check the exceptions. A short bridge, such as a loan from another source or the free-withdrawal amount of a different account, may cost less than $2,500.

What should I bring to a tax professional?

A short list makes the conversation faster:

1. Your birth date and the date of the planned withdrawal.
2. The most recent annuity statement showing value and, if available, basis.
3. Records of premiums paid, and any exchange paperwork.
4. The withdrawal amount and whether it is a lump sum, a series or a loan.
5. Any facts that might support an exception, such as disability records or the owner's death.
6. Your other income for the year, so the professional can estimate the ordinary tax too.
7. Any prior early withdrawals or a prior payment series, since earlier choices affect later ones.

A fee-only financial planner can help you compare the annuity withdrawal with other sources of cash. For disputes about a sale that left you without access to your money, the state insurance department takes complaints.

Key takeaways

• The 10% additional tax applies to the taxable part of an annuity withdrawal made before age 59½ unless an exception applies, and it is added to ordinary income tax.
• Because withdrawals from a non-qualified deferred contract generally come out gains first, the taxable part is usually most or all of an early withdrawal.
• The main exceptions are death, disability, substantially equal periodic payments, an immediate annuity and very old money, and the exceptions for IRAs and plans are a different list.
• A payment series must generally continue for five years or until 59½, whichever is later, and a change can bring back the tax on every earlier payment.
• Loans, collateral use and cash received in an exchange can count as taxable distributions, and the insurer does not usually collect the additional tax for you.