A common question I am often asked is, “What should I do with an old annuity?”
Maybe you decided years ago that it made sense to buy an annuity, were sold one without fully understanding it, or you had an agent explain it poorly to you.
People often buy an annuity, leave it for a decade or more, and then wonder what they should do with it. Unfortunately, annuities have different rules, so it can be challenging to determine what’s the highest and best use of the funds for you.
Let’s discuss the options for what to do with an old annuity, how it might be taxed, and how you can help make the decision for yourself about what to do with an old annuity.
Is the Annuity Qualified or Non-Qualified?
The first step is to determine whether the annuity is qualified or non-qualified.
The difference between a qualified and non-qualified annuity is simple.
- Qualified: The annuity was purchased with pre-tax money.
- Non-Qualified: The annuity was purchased with after-tax funds
This is important to know because if you have a qualified annuity, you can potentially roll the funds into an IRA and keep the tax-deferral. For example, if you had $100,000 in a qualified annuity, you may be able to cash it out, do a direct rollover to an IRA, and begin investing the funds into stocks, bonds, mutual funds, ETFs, etc.
If you have a non-qualified annuity, your options for tax-deferral are more limited.
What Type of Annuity Do You Own?
The next step is to determine what type of annuity you own. There are many types of annuities, all with different types of rules, riders, and other features, that can impact what you can do with it.
Below are common types of annuities to help you identify what you have.
Immediate Annuity
If you purchased an immediate annuity, that means you are already receiving income or will shortly.
Generally, if you are already receiving income, there is nothing you can do with this type of annuity. Usually, you hand over a lump sum and the insurance company agrees to pay you a specified amount for a certain period of time.
The only exception is if you recently bought an immediate annuity. Annuities generally have a “free look” period where you can change your mind and get out of the annuity contract.
Each state has a different free look period that is normally between 10 and 30 days. If you use the free look period, you may be able to get your money back.
Fixed Annuity
A fixed annuity is where you hand the insurance company a lump sum of money, and they agree to pay you a specific interest rate.
The interest rate may be fixed the first year, adjusts annually, but won’t go below a guaranteed minimum interest rate.
For example, you may receive a 6% interest rate the first year and the rate may go up or down the second year, but it may not go below 4%.
Multi-Year Guaranteed Annuity (MYGA)
A multi-year guaranteed annuity (MYGA) is where you turn over a lump sum of money to the insurance company that guarantees an interest rate for a certain period of time.
It’s very similar to a CD, but with tax deferral.
For example, you may get a 5 year MYGA that pays 6% for 5 years. The interest you earn is tax-deferred, which means you don’t report it until the end of the MYGA term.
Fixed-Indexed Annuity
A fixed-indexed annuity (FIA) has performance that is tied to different stock market indices.
Usually, fixed-indexed annuities have a floor of 0%, which means that if the stock market index return is negative, the annuity will have a return of 0%.
Fixed-indexed annuities also usually have a cap on performance. That can be in the form of a “participation rate” or a “cap” on the stock market index performance.
For example, an annuity may give you a participation rate of 50%, which means if the stock market, not including dividends (price return only), returns 10% over the specified time, you may receive 5%. If the FIA has a cap of 6% and the stock market returns 15%, the annuity will only credit a 6% return.
It’s critical to know that FIA returns are based on the index you select not including dividends, which means you only receive the price returns. Dividends can account for a good chunk of the return.
FIAs generally have bond-like returns that are tied to stock performance.
Variable Annuity
A variable annuity is an annuity that can invest in stocks, bonds, and other investments.
It’s similar to a 401(k) in that you normally have a preset menu of investment options and you receive tax-deferral on gains.
The downside to variable annuities is that on average, they tend to be expensive. There are inexpensive variable annuities, but many of them have a mortality and expense charge (M&E), mutual fund expenses, and other rider expenses if you select them. It’s not uncommon for total expenses to be above 2% on a variable annuity.
Options To Get Out of An Annuity
Your options for getting out of an old annuity will depend on the type of annuity you own.
If you don’t already have the original application you submitted to buy the annuity, ask the insurance company for a copy.
The fine print matters.
A key aspect to keep in mind is that if you get out of an annuity and you are under 59 ½, there is usually a 10% penalty on the earnings in addition to taxes.
There are a few exceptions in the case of death, disability, or certain payment streams, but it usually doesn’t apply to most people.
It’s important to know that annuities receive favorable tax treatment while you own them, but if you try to get money out of them, they are not favorable. The earnings are taxed first in an annuity.
When you withdraw money from an annuity, such as cashing it out, the earnings are taxed as ordinary income. This means is that if you paid $50,000 for an annuity and it was worth $100,000 when you cashed it out, you would have $50,000 of ordinary income that you would need to pay tax on at your marginal tax rate.
Even if you take withdrawals over time, such as 10% per year, the earnings are assumed to be taken out first, meaning any withdrawals are first taxed as ordinary income until you exhaust the total earnings. At that point, you can get your cost basis back tax-free.
For example, if you paid $50,000 for an annuity, it’s now worth $100,000, and you withdrew 10% per year, the first few years of withdrawals (approximately $10,000 per year) would be taxed as ordinary income before your cost basis could be taken out tax free.
Let’s look at your options to get out of an annuity.
Option #1 with an Old Annuity: Free Look Period
The first option to get out of annuity only applies if you are within the free look period.
This is the, “Oops, I want to undo what I just bought!” option.
Each state has a different free look period. For example, Washington state has a 10 day free look period. If you are replacing another annuity contract in Wisconsin, you have a 30 day free look period on the replacement contract.
If you are within the free look period, act quickly. You may still be able to get your money back and out of the annuity contract.
If you are outside the free look period, your options are more limited.
Option #2 with an Old Annuity: Cash Out the Annuity
A common option with an old annuity is to cash it out.
If it’s no longer serving the intended purpose and there is a better use of the funds, cashing it out and paying the taxes may be the ideal option.
Before cashing out the annuity, ask the insurance company for your cost basis, current market value, and if there are any surrender charges. Based on that information, you can calculate the gain in the annuity policy and how much in taxes you’d need to pay.
For example, if the gain in the policy is $50,000 and you are in the 24% federal tax bracket, you may owe about $12,000 in federal taxes. You’ll also want to estimate whether this income will affect any of the other taxes, like a net investment income tax (NIIT) or your Medicare premiums through an IRMAA surcharge.
Once you surrender or cash out the annuity, you can use the funds as if you had cash. You could deposit them in the bank, spend them, or invest them in a brokerage account (where you can receive capital gains tax treatment instead of ordinary income tax treatment).
Option #3 with an Old Annuity: Withdraw from the Annuity Over Time
Another option, particularly if you are still within the surrender period that has penalties, is to withdraw a certain percentage each year.
For example, many annuities allow you to withdraw 10% per year penalty-free.
This is one way to get out of the annuity over time, but you’ll still need to calculate how you will be taxed.
If you are withdrawing 10% per year, your first withdrawals will be taxed as ordinary income because earnings are taxed first. Once you withdraw all of the earnings, then you can withdraw your cost basis without being taxed.
Option #4 with an Old Annuity: Annuitize the Annuity into a Monthly Income
Another option with an old annuity is to annuitize it to receive a monthly income.
A few questions to ask yourself before going this route:
- Do you need the income or does Social Security, pensions, rental income, and investment withdrawals cover your needs?
- Are you worried about living a long time?
- Do you have other funds to help keep up with inflation?
- Is leaving an inheritance important?
- Do you know the difference between a payout rate and a rate of return?
Many people like the appeal of an annuity that pays income for life, but many don’t take the time to understand how it fits in their own financial plan.
I’ve seen people who have almost bought annuities, but Social Security and pensions cover most of their income already. Or, their investments can support their income needs well.
Annuitizing an annuity for lifetime income often only makes sense for people who expect to live a very long time and/or are very fearful of the market.
The downside to annuitizing an annuity is that many do not offer inflation adjusted income, meaning the income they receive today will be the same amount in 20 or 30 years. There are annuities that offer cost-of-living adjustments, but they tend to be very expensive in that they offer much lower starting monthly income.
If you do not have other investments to help keep up with inflation, you may find that the monthly income in 20 years is not enough to provide for your basic needs.
It’s also important to remember that once you annuitize an annuity, you’ve irrevocably turned over that money to the insurance company. If you want to leave an inheritance, you can’t do it with that money.
Lastly, don’t confuse a payout rate with a rate of return. I’ve had many people claim, “They will pay me 7%!”
That’s not a rate of return.
That’s most likely a payout rate or a rate tied to a guaranteed lifetime withdrawal benefit (GLWB).
If you give an insurance company $100,000 and they pay 7%, they may offer you $7,000 per year. You are spending your own money for the first 14 years ($100,000 / $7,000). In other words, you have a negative rate of return for the first 14 years.
It’s not until after 14 years that you start to earn a positive rate of return.
The other aspect to watch is any annuity with multiple rates or riders. Generally, the more complicated the product, the worse it is.
Don’t be fooled by insurance companies’ advertising. They are very good at using terms and rates that are difficult to calculate your actual rate of return.
There are good reasons to annuitize an annuity to receive a lifetime income, but make sure you understand it and are doing it for the right reasons.
Option #5 with an Old Annuity: 1035 Exchange to Another Annuity
Another popular option with an old annuity is to do a 1035 exchange into another annuity.
This is a popular option because it allows you to defer the gain in the annuity. For example, if you paid $50,000 for an annuity and it is worth $100,000 today, if you cashed it out, you’d pay ordinary income on $50,000.
If you did a 1035 exchange, you can transfer the full $100,000 into a different annuity and not pay taxes if done properly.
This can be a good option if you have high gains in a policy and an annuity still fits within your overall financial plan. Perhaps a different annuity has better rates or different features, such as a long-term care rider, that is a better use of the funds at your current stage of life.
Before doing a 1035 exchange, treat it like a new annuity purchase because that is what it is. Be aware of any new surrender periods. It’s a new purchase, which means if you are out of your old surrender period, you will start a new one, which could be 6 to 10 years.
Also, be careful before doing a 1035 exchange and make sure it’s in your best interest. Your agent may be suggesting it because they can earn a new commission on the 1035 exchange since you are purchasing a new annuity.
A 1035 exchange of an old annuity into a new annuity can potentially get you an annuity with higher rates or better features for your current lifestyle.
Option #6 with an Old Annuity: Keep the Annuity
The last option for an old annuity is simply to keep it.
Sometimes a new annuity doesn’t make sense with a 1035 exchange, you may be in a high tax bracket where it doesn’t make sense to cash it out yet, and annuitizing it doesn’t make sense.
If that’s the case for you, double check that you are in the appropriate options. This may include selecting different investments, removing or adding riders (if possible), and making a calendar reminder to revisit it on a certain date.
I see far too many people purchase an old annuity, not fully understand it, select options, and then let it go by for years or decades.
An annuity, like any other investment, needs to be carefully monitored to make sure it is working in coordinating with everything else for your financial independence.
Final Thoughts – My Question for You
Deciding what to do with an old annuity is not a straightforward decision.
You first need to understand whether the funds are qualified or non-qualified, what type of annuity you have, how much you paid for, and the current market value today.
From there, you can start to explore other options, such as cashing it out, annuitizing it, or doing a 1035 exchange.
I’ll leave you with one question to act on.
What is your first step in evaluating what to do with an old annuity?
