What to Do With an Annuity: Withdraw, Convert, Exchange, or Sell

If you own an annuity, you have four live choices: take cash out (partial or full surrender), convert the balance into guaranteed income payments, swap it tax-free for a different annuity, or sell future payments to a third party for a lump sum. If you inherited one, your path is narrower and the clock is already running. What to do with an annuity depends on the contract’s surrender schedule, whether it’s qualified or non-qualified, your age, and your tax picture. Every option has a different tax result, and taking money out at the wrong time can add a 10% federal penalty on top of ordinary income tax.¹

Read the Contract Before You Decide Anything

Pull out the policy. The front page tells you whether you own a fixed annuity (guaranteed interest rate), a variable annuity (returns tied to subaccounts you choose), or an indexed annuity (growth linked to a market benchmark like the S&P 500 without direct market exposure). Each type has different fees, risks, and withdrawal rules.

The surrender schedule is the single most expensive detail people overlook. Most contracts charge a declining percentage if you withdraw during the first several years. A typical schedule might start at 6% in year one and drop a point each year until it hits zero, though schedules anywhere from three to ten years are common. Many contracts also include a free withdrawal provision letting you pull out a percentage of the account value each year without surrender charges. Ten percent is widespread; some contracts cap it at 5% or allow nothing. This is a contractual feature, not a legal requirement, so your contract is the only authority on your numbers.

The contract names three roles. The owner controls the contract and makes all decisions. The annuitant is the person whose life expectancy drives payout calculations. The beneficiary receives any remaining value at death. These can be the same person or different people, and 1035 exchange rules care about which is which.

Before anything else, call the carrier and request a current surrender value statement. That gives you the exact dollar amount available today, after charges. If you own a variable annuity, ask for the total of mortality and expense charges, administrative fees, and any rider costs; those are deducted daily from subaccount balances and are easy to miss on a quarterly statement.

Qualified or Non-Qualified Changes the Tax on Every Option

How the annuity was funded controls how every dollar coming out is taxed. A qualified annuity lives inside a tax-advantaged account like an IRA, 401(k), or 403(b). It was funded with pre-tax dollars, so the full amount of every withdrawal is ordinary income.² A non-qualified annuity was purchased with money you already paid taxes on; only the earnings portion is taxable, because your original contributions (your “basis”) have already been taxed once.

Qualified annuities also carry required minimum distributions. If you turn 73 after December 31, 2022, and before January 1, 2033, you must start withdrawals by April 1 of the year after you reach 73. That threshold rises to 75 for anyone turning 74 after December 31, 2032.³ Miss an RMD and the IRS imposes a 25% excise tax on the amount you should have taken. Non-qualified annuities have no RMDs during the owner’s lifetime.

Taking Cash Out

You can take money two ways: a partial withdrawal that keeps the contract alive, or a full surrender that ends the contract and sends you the remaining balance as a lump sum. Partial withdrawals are the more common starting point, especially if your free withdrawal provision lets you pull a percentage each year without surrender charges.

How Withdrawals Get Taxed

Non-qualified annuity withdrawals follow a last-in, first-out rule. Every dollar is treated as taxable earnings until the earnings are exhausted; only then do withdrawals come from your tax-free basis.¹ If you put $100,000 in and the contract grew to $140,000, the first $40,000 out is fully taxable as ordinary income. Qualified annuity withdrawals are simpler but more painful: the entire distribution is ordinary income, since no after-tax dollars went in.² Your carrier reports every distribution to the IRS on Form 1099-R, showing both the gross amount and the taxable portion.⁴

The 10% Early Withdrawal Penalty

If you take money from an annuity before age 59½, the IRS adds a 10% penalty on top of the income tax owed. It applies to the taxable portion of the withdrawal.¹ Several exceptions eliminate it:

Distributions to beneficiaries after the owner’s death.
Total and permanent disability.
A series of substantially equal periodic payments based on your life expectancy, which must be maintained for at least five years or until you reach 59½, whichever is later. Changing the amount early triggers back-penalties with interest.
Payments from an immediate annuity contract.

The penalty is separate from surrender charges. You can owe both the IRS penalty and the insurer’s surrender fee on the same withdrawal if you’re young enough and early enough in the contract.⁵

Converting the Balance Into Income Payments

Annuitization converts your account balance into a guaranteed stream of payments. Once you annuitize, the insurer takes your lump sum and sends checks on a set schedule. The decision is almost always irrevocable, so the payout structure you pick is the one you live with.

The three standard structures:

Life only. Payments continue as long as you live. When you die, payments stop and nothing goes to heirs. This produces the highest monthly payment because the insurer keeps whatever balance remains.
Joint and survivor. Payments continue until both you and a second person (usually a spouse) have died. Monthly payments are lower because the insurer expects to pay for two lifetimes.
Period certain. Payments are guaranteed for a set number of years, such as 10 or 20. Die before the period ends and your beneficiary receives the remaining payments. Outlive it and payments stop.

Some contracts offer hybrids combining life and period-certain features. The more protection against outliving your money or leaving something to heirs, the smaller each payment.

When you annuitize a non-qualified annuity, each payment is split into a taxable portion (earnings) and a tax-free portion (return of your original investment). The IRS calls this the exclusion ratio: your total investment divided by your expected total return gives the percentage of each payment that’s tax-free.¹ Once you’ve recovered your entire investment tax-free, every later payment is fully taxable. If you die before recovering the full investment, the unrecovered amount can be claimed as a deduction on your final tax return. Qualified annuity payments use a different method, the Simplified Method, laid out in IRS Publication 575.⁶ Non-qualified contracts follow the General Rule in Publication 939.⁷

Exchanging for a Different Annuity

If your current annuity has high fees, poor investment options, or a rider you don’t need, you can swap it for a different annuity without owing tax on the gains. Federal law allows this through a 1035 exchange.⁸

The rules are strict. The funds must transfer directly from one insurer to the other. If the money passes through your hands at any point, the IRS treats it as a taxable distribution and you’ll owe income tax on the gains plus a potential 10% penalty if you’re under 59½. The exchange must also keep the same owner and annuitant on both contracts; IRS guidance limits tax-free treatment to cases where the same person or persons are the payees under both the old and new contracts.⁹

A 1035 exchange can also move a life insurance policy into an annuity, or an annuity into a qualified long-term care insurance contract. It cannot run the other direction: you can’t exchange an annuity for a life insurance policy.⁸ One thing a 1035 does not do is reset the surrender schedule on the old contract. If your current annuity still has surrender charges, you pay them when the money leaves. The new contract then starts its own fresh surrender period.

Selling Future Payments for a Lump Sum

This option applies mainly to structured settlement annuities, where you’re receiving fixed payments from a legal settlement and need cash now instead. A factoring company buys your right to some or all of the future payments for an upfront amount. That amount is less than the total face value of the payments, because the buyer applies a discount rate to the present value of money received over time.

Selling structured settlement payments requires court approval in most states. A judge reviews the transaction under state structured settlement protection laws and decides whether it serves your best interest. You’ll need to explain why you need the lump sum and show the sale won’t leave you or your dependents in financial jeopardy.

Selling payments from a commercial annuity you bought yourself is a different and less regulated process that doesn’t always require court approval. Either way, the tax consequences can be significant, and the discount rates factoring companies apply mean you’ll receive substantially less than the remaining payment total.

If You Inherited the Annuity

Your options depend on whether the annuity is qualified or non-qualified, when the original owner died, and your relationship to the deceased. Getting this wrong triggers unexpected tax bills or IRS penalties.

Non-Qualified Inherited Annuities

When someone dies holding a non-qualified annuity before the payout phase begins, federal law requires the entire balance to be distributed within five years of the owner’s death.¹ You can take the money out in any combination of withdrawals during that window, as long as the account is empty by December 31 of the fifth year.

A designated beneficiary can instead stretch distributions over their own life expectancy, but only if payments begin within one year of the owner’s death. Miss that one-year deadline and you’re locked into the five-year rule. A surviving spouse gets the most favorable treatment: the law treats the spouse as the new owner, which means they can continue deferring the annuity and aren’t forced to take distributions at all.

Qualified Inherited Annuities and the 10-Year Rule

If the annuity was inside an IRA or employer retirement plan, the SECURE Act rules apply for deaths in 2020 or later. Most non-spouse beneficiaries must empty the account by the end of the tenth year after the owner’s death.¹⁰ There’s no option to stretch over your own lifetime unless you qualify as an “eligible designated beneficiary.” That category is limited to:

Surviving spouses.
Minor children of the deceased account holder, but only until they reach the age of majority, after which the 10-year clock starts.
Disabled or chronically ill individuals.
Beneficiaries no more than 10 years younger than the deceased owner.

Eligible designated beneficiaries can take distributions based on their own life expectancy or elect the 10-year rule. Everyone else follows the 10-year rule with no flexibility.

Spousal Options

Surviving spouses have the widest range of choices for inherited qualified annuities. A spouse can roll the account into their own IRA and treat it as if it had always been theirs, which resets the RMD clock to their own age. They can keep it as an inherited account and take distributions based on their life expectancy. Or they can delay distributions until the deceased would have reached RMD age.¹⁰ The spousal rollover is almost always the most tax-efficient route for someone who doesn’t need the money immediately. For non-qualified annuities, a surviving spouse can step into the owner’s shoes and continue the contract as their own, avoiding forced distributions entirely.

Starting the Claim

Whichever path you choose, the insurer will require a certified death certificate and completed beneficiary claim forms before releasing any money. Timing matters. If you’re planning to use the life-expectancy stretch on a non-qualified annuity, or as an eligible designated beneficiary of a qualified plan, the first distribution must begin before the end of the calendar year following the year of death.⁶ Paperwork delays that push you past that deadline can permanently eliminate the stretch option, so file promptly.

1
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Topic No. 410, Pensions and Annuities
3
Federal Register. Required Minimum Distributions
4
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.
5
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
6
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
7
Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities
8
Office of the Law Revision Counsel. 26 U.S.C. 1035 – Certain Exchanges of Insurance Policies
9
Internal Revenue Service. Rev. Proc. 2011-38, Section 1035 Exchanges
10
Internal Revenue Service. Retirement Topics – Beneficiary