Cashing in an annuity early can trigger up to three costs at once: a surrender charge from the insurance company, ordinary income tax on the earnings inside the contract, and a 10% federal penalty on the taxable portion if you are under 59½. How much you actually lose depends on your contract’s surrender schedule, whether the annuity was funded with pre-tax or after-tax money, and how long you have owned it.
The Insurance Company’s Surrender Charge
When you buy an annuity, the insurer typically locks in a surrender period of six to ten years. Pull money out during that window and you owe a fee. The charge follows a declining schedule: a common structure starts at 7% of the amount withdrawn in year one and drops by roughly one percentage point each year until it hits zero.
Most contracts include a free withdrawal allowance, often 10% of the account value per year, that you can take without paying the surrender charge. If you withdraw more than the free amount, the charge applies only to the excess, not to the entire distribution.
Some fixed and fixed-indexed annuities add a market value adjustment on top of the surrender charge. The MVA recalculates your payout based on how interest rates have moved since you bought the contract. If rates have risen, the adjustment reduces what you receive; if rates have fallen, it increases it. In a rising-rate environment, the total drag can exceed the posted surrender percentage alone.
Income Tax on What You Withdraw
How the IRS taxes your withdrawal depends on whether the annuity is qualified or non-qualified. Getting this wrong can leave you with a much bigger tax bill than you expected.
Non-Qualified Annuities
A non-qualified annuity was funded with after-tax dollars. Before the contract is annuitized, the IRS treats earnings as coming out first under a last-in, first-out approach. Every dollar you withdraw is fully taxable as ordinary income until you have pulled out all the accumulated gains.1Internal Revenue Service. Publication 575 – Pension and Annuity Income Only after the earnings are exhausted do further withdrawals count as a tax-free return of your original investment.
Qualified Annuities
A qualified annuity sits inside an IRA, 401(k), or similar retirement account and was funded with pre-tax dollars. Because you never paid income tax on the contributions, the entire withdrawal, both principal and earnings, is taxed as ordinary income when it comes out.2Internal Revenue Service. Topic No. 410 – Pensions and Annuities There is no tax-free portion.
The 10% Federal Penalty Before 59½
On top of ordinary income tax, the IRS adds a 10% tax on the taxable portion of any annuity distribution you take before age 59½. For non-qualified annuities, this penalty comes from Internal Revenue Code Section 72(q). For qualified annuities held inside retirement plans, the parallel rule is Section 72(t).3Office of the Law Revision Counsel. 26 USC 72 – Annuities, Certain Proceeds of Endowment and Life Insurance Contracts The 10% is calculated on the taxable portion only, not on the full amount you receive.
Ways to Avoid or Reduce the Penalty
Section 72(q)(2) lists several situations where the 10% additional tax does not apply, even if you are under 59½:
- Death of the owner. Distributions paid to a beneficiary after the contract holder dies are exempt.3Office of the Law Revision Counsel. 26 USC 72 – Annuities, Certain Proceeds of Endowment and Life Insurance Contracts
- Disability. The penalty is waived if you cannot engage in any substantial gainful activity because of a medically determinable impairment expected to result in death or last indefinitely.
- Substantially equal periodic payments. You can set up a series of roughly equal annual payments based on your life expectancy. They must continue for five years or until you reach 59½, whichever period is longer. Modify or stop them too early and the IRS retroactively applies the 10% penalty plus interest to every distribution you already took.4Internal Revenue Service. Substantially Equal Periodic Payments
- Immediate annuity. Distributions from a contract that begins paying income within a year of purchase are exempt.
- Contributions made before August 14, 1982. Any portion tied to pre-1982 investment is not subject to the penalty.
Contract Riders That Waive the Surrender Charge
Many annuity contracts include riders that waive the insurer’s surrender fee under specific hardships. A nursing home confinement rider typically waives the fee if the owner or annuitant is confined to an eligible care facility for at least 90 consecutive days after the first contract anniversary.5Securities and Exchange Commission. Waiver of Withdrawal Charge for Nursing Home or Hospital Confinement Rider A terminal illness rider may waive the charge if a physician certifies a life expectancy of fewer than 12 months. These riders waive the insurance company’s fee only. They do not override the IRS’s 10% penalty, which has its own separate disability exception.
Alternatives to a Full Surrender
Cashing out entirely is not the only way to reposition or access money in an annuity.
- 1035 exchange. Under IRC Section 1035, you can transfer the value of one annuity directly into a new annuity or into a qualified long-term care insurance policy without recognizing any taxable gain. The new contract must be in the same owner’s name and the transfer must go directly between insurers. A 1035 exchange avoids income tax and the 10% penalty, though the old insurer may still charge a surrender fee if you are within the surrender period.6Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
- Free withdrawal only. Taking just the annual free amount, often 10% of account value, avoids the surrender charge. You still owe income tax and, if applicable, the 10% penalty on the taxable portion.
- Annuity loans. A small number of contracts allow loans against the account value. If yours does, the loan is not treated as a taxable distribution while it remains outstanding. Most annuities do not offer this feature, so check the contract.
What Cashing Out Does to Your Riders
If your annuity carries a guaranteed lifetime withdrawal benefit or guaranteed minimum income benefit, taking more than the rider’s allowed annual amount can permanently shrink the benefit. Conforming withdrawals, those within the guaranteed amount, do not reduce the income base used to calculate future guaranteed payments.
Excess withdrawals cut the income base proportionally rather than dollar-for-dollar. If a $10,000 excess withdrawal reduces your account value by 8%, the income base also drops by 8%, which can be far more than $10,000 in dollar terms when the income base sits higher than the account value.7Securities and Exchange Commission. Variable Annuity Living Benefits Rider The same proportional reduction typically applies to any enhanced death benefit on the contract. Ask the insurer for a projection before pulling any large withdrawal.
How to Request the Withdrawal
Contact the insurance company for its official withdrawal or surrender form. You will choose between a partial withdrawal of a specific dollar amount and a full surrender that closes the contract.
The form asks how much federal income tax to withhold. For a lump-sum or other nonperiodic payout, the default withholding rate is 10%. You can pick a different rate anywhere from 0% to 100% by submitting IRS Form W-4R with your paperwork.8Internal Revenue Service. 2026 Form W-4R – Withholding Certificate for Nonperiodic Payments and Eligible Rollover Distributions For an eligible rollover distribution from a qualified plan, the default is 20% and cannot be reduced below that. State withholding may also apply.
If the annuity sits inside a defined benefit, money purchase, or target benefit plan, federal rules generally require your spouse to sign a consent form before the insurer can pay you in any form other than a joint-and-survivor annuity. This applies to both lump-sum surrenders and partial withdrawals, with an exception when the total benefit is $5,000 or less.9Internal Revenue Service. Fixing Common Plan Mistakes – Failure to Obtain Spousal Consent Non-qualified annuities and most profit-sharing or 401(k) plans do not carry this requirement.
Processing typically takes a few weeks after the insurer receives complete paperwork. Once the distribution is issued, the company sends IRS Form 1099-R reporting the gross distribution, the taxable amount, and any tax withheld.10Internal Revenue Service. Instructions for Forms 1099-R and 5498 Keep it for the tax return covering the year of the withdrawal.