The Tax Consequences of Cashing in an Annuity

by Sue-Lynn Carty

Most annuities are designed as long-term investment vehicles. Deferred annuities defer payments until a later date, while immediate annuities typically begin making payments right away. When an annuitant -- the person who owns the annuity contract -- cashes in his deferred annuity before the contract annuitizes or before he is age 59 1/2, he will likely have to pay an early withdrawal tax penalty and income taxes on the annuity proceeds.

Immediate and Deferred Annuities

When people purchase immediate annuities, they make one lump sum payment into the annuity and begin receiving their monthly income payments within 30 days of the deposit. When people purchase deferred annuities, they make one lump sum payment or multiple payments over time into the annuity. Once their contract annuitizes or once they reach age 59 1/2, their annuity pays them a guaranteed monthly income stream.

Immediate Annuities

If a person owns an immediate annuity, she cannot cash it in with the annuity company. Instead, she would have to sell it on the secondary market. To do so, she would have to contact a company that purchases structured settlements. When she sells her annuity, the IRS will tax any gains she made on the investments inside the annuity at her regular federal income tax rate. If she sells her annuity before she is 59 1/2, she will also have to pay the IRS an early withdrawal penalty fee of 10 percent.

Deferred Annuities

Unlike immediate annuities, a person who owns a deferred annuity may cash it in with the annuity company before reaching age 59 1/2. If he decides to do so, the IRS will tax any gains on the annuity at his regular income tax rate and he will pay a 10 percent tax penalty for cashing in his annuity before age 59 and 1/2.

Surrender Charges

One other consequence of cashing in an annuity that all annuity owners need to consider is the surrender charge. Surrender charges are the fees that the annuity company charges people for surrendering, or cashing in their annuities during the surrender period. Surrender periods vary and typically last for years. Surrender charges also vary by annuity company, but are always a percentage of the value of your annuity contract.

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