Annuities are not liquid assets. Once the brief free-look window at purchase closes, the contract restricts how much you can withdraw, and taking more than a small annual allowance before the surrender period ends can cost you surrender charges of 7% or more, ordinary income tax on the earnings, and a 10% federal penalty if you are under 59½. A liquid asset is one you can convert to cash quickly without losing significant value, and annuities fail that test by design.
Why Annuities Fail the Liquidity Test
Two features put annuities firmly in the illiquid column. The contract locks your money in for a set period, often seven to ten years, while the insurance company invests it to fund future payouts. And pulling money out early triggers surrender charges, tax consequences, or both.
A deferred annuity has two phases, and neither one gives you free access. During the accumulation phase, your contributions grow through interest or investment returns, but the insurer controls the funds and penalizes withdrawals above a small annual allowance. During the payout phase, the annuity distributes income in scheduled installments rather than handing you the full balance. The point of the product is guaranteed future income, and the restrictions exist to protect that promise.
The One Time an Annuity Is Fully Liquid: the Free-Look Period
Every annuity contract comes with a brief free-look period, during which you can cancel and get a full refund of your premium with no surrender charges or penalties. The National Association of Insurance Commissioners sets a floor of at least 15 days when disclosure documents were not provided before purchase.1NAIC. Annuity Disclosure Model Regulation State laws extend this period in many cases, with windows ranging from 10 to 30 days depending on your state and age. After the free-look period closes, the surrender schedule takes effect, and the contract is no longer liquid.
The Small Amount You Can Take Each Year
Most annuity contracts include a free withdrawal provision that lets you take out a portion of your account value each year without paying surrender charges. The allowance is typically 10% of the contract value or the original premium.
A few things to know. If you do not use your free withdrawal in a given year, the unused portion generally does not carry over. Any amount beyond the free allowance triggers surrender charges. And “free” means free of surrender charges only: withdrawals within the allowance can still be subject to ordinary income tax and the 10% early withdrawal penalty if you are under 59½.
Crisis Waivers That Unlock the Contract
Some annuity contracts include crisis waiver riders that let you withdraw money, or surrender the contract entirely, without paying surrender charges when certain qualifying events occur. Common triggers include:
- Terminal illness
- Nursing home confinement
- Disability that prevents you from working
- Death, in which case the beneficiary receives the death benefit without surrender charges
Crisis waivers are contractual features, not legal requirements. Not every annuity includes them, and the qualifying conditions vary. If liquidity during a health emergency matters to you, check whether your contract has one before you need it. Even when surrender charges are waived, income taxes and the federal early withdrawal penalty may still apply to the taxable portion.
What Early Withdrawals Actually Cost
Surrender Charges
When you withdraw more than the free allowance before the surrender period ends, the insurer deducts a surrender charge. These charges recoup the administrative costs and commissions the insurer paid when it issued the contract. A typical schedule starts at around 7% in the first year and drops by roughly one percentage point each year until it reaches zero, often by year seven or eight. Some contracts use higher starting charges or longer schedules.
Market Value Adjustments
Some fixed and fixed-indexed annuities also include a market value adjustment that can increase or decrease the amount you receive on an early withdrawal. The adjustment compares current interest rates to the rates in effect when you bought the annuity. If rates have risen since your purchase, the insurer’s existing investments backing your annuity are worth less, and the adjustment reduces your payout. If rates have fallen, your payout may increase. A market value adjustment can add several percentage points of loss on top of the surrender charge when rates have moved significantly.
Ordinary Income Tax on Earnings
How withdrawals are taxed depends on whether the annuity is non-qualified (purchased with after-tax dollars) or qualified (held inside a traditional IRA, 401(k), or similar account).
For non-qualified annuities, the IRS treats withdrawals before the payout phase as coming from earnings first and your original contributions second.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Every dollar you withdraw is fully taxable as ordinary income until all the accumulated earnings are gone. Only after the earnings are exhausted do you start getting your cost basis back tax-free. IRS Publication 575 confirms this ordering rule.3Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
For qualified annuities, you never paid taxes on the money going in, so 100% of every withdrawal is ordinary income. If the annuity sits inside a traditional IRA, you also must begin taking required minimum distributions once you reach age 73, even if you have not annuitized.4Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs Missing an RMD triggers a separate IRS penalty, so a qualified annuity actually forces a degree of liquidity whether you want it or not.
The 10% Early Withdrawal Penalty
On top of regular income tax, the IRS imposes a 10% additional tax on the taxable portion of any annuity withdrawal taken before you turn 59½.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Combined with surrender charges and ordinary income tax, this penalty can consume a large share of an early withdrawal.
Federal law carves out several exceptions where the 10% penalty does not apply:2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
- You are 59½ or older.
- The distribution is made to a beneficiary after the owner’s death.
- You become disabled and unable to engage in substantial gainful activity.
- You take a series of substantially equal periodic payments over your life expectancy. Once you start, you must continue for at least five years or until you reach 59½, whichever is later.
- The payments come from an immediate annuity contract.
- The amounts are attributable to investment in the contract made before August 14, 1982.
These exceptions apply only to the federal 10% penalty. Ordinary income tax still applies to the taxable portion, and surrender charges imposed by the insurance company are a separate cost that none of these exceptions waive.
Immediate Annuities Are the Most Illiquid Type
With a single premium immediate annuity, you hand over a lump sum and the insurance company converts it into a guaranteed income stream that starts right away. Your original principal effectively disappears as a reachable asset and is replaced by scheduled payments. You cannot reclaim the remaining principal, and because immediate annuities are purchased to provide income, they generally cannot be surrendered at all. Deferred annuities hold a cash value you can at least attempt to reach, with consequences; immediate annuities take even that option off the table.
Switching Contracts Without Cashing Out
If your current annuity no longer fits your needs, you can exchange it for a new annuity contract without triggering any taxable gain. Federal law allows a direct swap of one annuity for another annuity, or for a qualified long-term care insurance contract, with no tax consequences at the time of the exchange.5Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
A 1035 exchange does not give you cash in hand. The funds transfer directly from one insurance company to another, and the new contract has its own surrender schedule that typically restarts from year one. So an exchange does not improve the liquidity of the underlying asset. It only lets you move to a better contract without the tax hit of surrendering and reinvesting on your own, which would not qualify.
When the Money Becomes Accessible: Death of the Owner
Death is one situation where annuity funds become more accessible. If the owner dies before the payout phase begins, the contract’s death benefit pays out to the named beneficiary, typically the greater of the account value or total premiums paid. The 10% early withdrawal penalty does not apply to distributions made after the owner’s death, regardless of the beneficiary’s age.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The beneficiary can usually choose between a lump sum, payments over a fixed period, lifetime payments, or systematic withdrawals, with ordinary income tax still applying to the earnings (or the full amount for a qualified annuity). Spousal beneficiaries often have the additional option of continuing the contract in their own name.
A Note on Medicaid and SSI
Although annuities are illiquid in a practical sense, government benefit programs may still count them as resources. A revocable deferred annuity, meaning one you can cancel to receive the cash value, is generally treated as a countable resource for both Medicaid long-term care eligibility and Supplemental Security Income. The SSI resource limit in 2026 is $2,000 for an individual and $3,000 for a couple.6Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet From the program’s perspective, if you have the legal ability to cash it out, it counts as available money, even if cashing it out would cost you a large share of the balance. Medicaid also applies a 60-month look-back period to annuity purchases and restructurings, and strict federal rules govern when an irrevocable annuity can be treated as income rather than an asset.7Office of the Law Revision Counsel. 42 USC 1396p – Liens, Adjustments and Recoveries, and Transfers of Assets If benefit eligibility is on the horizon, do not assume illiquidity protects the asset from being counted.