Terminating an Annuity

Question: What happens when a contract owner terminates an annuity?

Annuities are powerful financial tools used to provide income over a period, often during retirement. However, situations can arise where a contract owner might decide to terminate their annuity. Terminating an annuity can have significant financial and tax implications, and it is important to understand the various aspects involved. This guide provides a detailed look into the considerations and steps involved in terminating an annuity.

Understanding Annuities

An annuity is a financial product sold by financial institutions like insurance companies and is designed to grow funds and then pay out a stream of income. Annuities are particularly popular for retirement planning due to their ability to provide consistent income streams. There are several types of annuities, including:

• Fixed Annuities: Offer a guaranteed payout.
• Variable Annuities: Payouts vary based on the performance of the investment options chosen.
• Indexed Annuities: Offer returns based on a specified equity-based index.

Reasons for Terminating an Annuity

Several factors might lead a contract owner to consider terminating their annuity. These can include:

• Financial Need: Immediate liquidity needs may force termination.
• Change in Financial Goals: Shifts in retirement plans or investment strategies.
• Poor Performance: Especially relevant with variable annuities where the market performance is unsatisfactory.
• Better Investment Opportunities: Emerging options offering more favorable returns or terms.

Considerations Before Termination

Financial Penalties

1. Surrender Charges: Most annuities feature a surrender charge for early withdrawal, which can last for up to ten years after purchase. These charges typically range between 7% and 20%.

2. Market Value Adjustments: For some fixed annuities, terminating might lead to market value adjustments, affecting the contract's final value based on prevailing interest rates.

Tax Consequences

1. Ordinary Income Tax: Annuity distributions are usually subject to ordinary income tax, especially for gains.

2. Early Withdrawal Penalty: If under the age of 59½, a 10% IRS early withdrawal penalty might apply in addition to regular income taxes.

Loss of Benefits

• Death Benefits: Certain annuities come with guaranteed death benefits which could be lost upon termination.
• Lifetime Income Guarantees: The certainty of having a guaranteed income stream is forfeited, which might not be easily replaceable.

Process of Terminating an Annuity

Step 1: Review Contract Terms

Start by thoroughly reviewing your annuity contract to understand the specifics such as surrender charges, penalties, or any clauses that might impact your decision.

Step 2: Consult a Financial Advisor

Engage with a financial advisor to explore all the ramifications of terminating your annuity, including financial, tax, and future planning considerations.

Step 3: Contact the Issuing Company

Reach out to the insurance or financial institution that issued the annuity to gain insights on the formal process, required documentation, and potential impacts.

Step 4: Calculate Exact Payout

Obtain a precise calculation of the payout amount post-penalties, taxes, and other deductions.

Step 5: Consider Alternatives

Evaluate alternatives such as partial withdrawals, annuitizing the account for lifetime income, or a 1035 exchange to switch to another annuity product without immediate tax liabilities.

Step 6: Initiate Termination

Provide the necessary documentation, usually involving a termination form. Ensure all information is complete and accurate to avoid processing delays.

Step 7: Plan for Funds

Develop a plan for how the received funds will be reinvested or utilized in alignment with financial goals.

Alternatives to Termination

1. Partial Withdrawals: Some annuities permit partial access to funds without full termination, offering liquidity without complete surrender of benefits.

2. Annuitizing the Contract: Turning your annuity into a lifetime income stream can preserve benefits while providing a steady income.

3. 1035 Exchange: This is a tax-advantaged way to transfer your annuity to another one that better meets your needs.

Example Scenario

Consider John, who has a variable annuity that he purchased with a $100,000 premium. His annuity has grown to $150,000, but he needs liquidity. If John terminates his annuity:

• He incurs a surrender charge of 7% on the $150,000, amounting to $10,500.
• His taxable gain is $50,000, which will be included as ordinary income.
• As John is 55, a 10% early withdrawal penalty may apply to the taxable portion.
• After taxes and penalties, John realizes that he will net significantly less than the annuity's value.

FAQ

Can I avoid surrender charges?

Surrender charges may be avoided if the annuity is past its surrender period. Defined by contract, this varies but is often between 5 and 10 years.

What is a 1035 exchange?

A 1035 exchange allows tax-free transfers between life insurance policies, annuities, or life insurance to annuities, preserving investment gains from immediate taxation.

How do taxes work on annuity termination?

Any distributed earnings above the original premium are subject to ordinary income tax. For those under 59½, a 10% tax penalty can also apply.

Are inherited annuities different?

Yes, inherited annuities may have different rules. Heirs also pay taxes on growth as ordinary income but might use different distributions forming favorable tax treatment.

Exploring Further

For further exploration, consider reaching out to financial planning resources or certified financial planners to tailor the decision to your unique financial situation. Annuities and financial products are complex, and decisions regarding them should be based on comprehensive understanding and good advice.

The decision to terminate an annuity is multifaceted, involving thorough evaluation of financial repercussions, understanding of contract terms, and a strategic approach to the use of resulting funds. While the process may seem daunting, with careful planning and informed decision-making, you can navigate these waters effectively.