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What Annuities Are and How Withdrawal Rules Work

An annuity is a financial contract between you and an insurance company. You give the company money—either in one lump sum or over time—and in return, the company promises to pay you money later, often for the rest of your life. Think of it as a personal pension you can purchase.

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There are different types of annuities. A fixed annuity pays you the same amount each month or year. A variable annuity's payments change based on how investments perform. An immediate annuity starts paying you right away. A deferred annuity waits until a date you choose to begin payments. Each type has different rules about when and how you can take money out.

Withdrawal rules matter because they affect how much money you actually receive and whether you face penalties. Insurance companies and the government have created these rules to prevent people from withdrawing money too early or in ways that create tax problems. Understanding these rules helps you make informed decisions about your money.

The IRS sets rules for many annuities, especially those held in retirement accounts like IRAs. These rules determine when you can withdraw money without penalties and what taxes you owe. State insurance departments set additional rules for how insurance companies must handle annuities. Your specific annuity contract also contains its own rules, which may be stricter than government requirements.

According to the U.S. Securities and Exchange Commission, about 2.2 million annuities are sold each year in the United States. Many people own annuities but don't fully understand their withdrawal options. This creates confusion when people need to access their money or want to know what options exist.

Practical Takeaway: Before reading further, locate your annuity contract or any paperwork you have from your insurance company. Write down the type of annuity you have (fixed, variable, immediate, or deferred) and when you purchased it. This information will help you understand which withdrawal rules apply to your specific situation.

Early Withdrawal Penalties and When They Apply

Many annuities come with a "surrender period," which is a set number of years during which the insurance company penalizes you for withdrawing more than a certain amount. These surrender periods typically last 5 to 10 years, though some last as long as 15 years. The penalty, called a "surrender charge," reduces the amount of money you actually receive.

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Surrender charges work like this: Imagine you bought a $100,000 annuity with a 7-year surrender period and a 7% surrender charge. If you tried to withdraw $50,000 in year 3, the insurance company might deduct a surrender charge based on your withdrawal. However, most annuities allow you to withdraw a small percentage each year—often 10% or less—without penalty. So in this same example, you might be able to withdraw $10,000 per year without any surrender charge, but withdrawing $50,000 would trigger the charge on the amount over your free withdrawal percentage.

Beyond surrender charges, the IRS adds another penalty for certain annuities. If you own an annuity inside a retirement account (like a traditional IRA) and withdraw money before age 59½, you typically face a 10% IRS penalty on the withdrawal, plus you owe regular income taxes on the money. There are some exceptions to this penalty, including:

• Withdrawals for medical expenses that exceed a certain percentage of your income
• Withdrawals due to disability or a serious illness
• Withdrawals taken as part of a series of equal payments over your life expectancy
• Withdrawals to pay for health insurance while unemployed
• Withdrawals to pay IRS back taxes

Non-annuity withdrawals also face penalties. If you have a non-qualified annuity (money not in a retirement account), early withdrawals may trigger the 10% penalty only on the earnings portion, not on the money you originally invested. This is because you already paid taxes on your original deposit with after-tax dollars.

The surrender charge typically decreases over time. If your surrender period is 10 years and the charge starts at 10%, it might decrease by 1% each year. By year 10, the surrender charge reaches zero. After the surrender period ends, you generally can withdraw your money without a surrender charge from the insurance company, though you may still owe taxes.

Practical Takeaway: Check your annuity contract for the surrender period length and current surrender charge percentage. Calculate how many years remain in your surrender period. If you think you might need money soon, understand that withdrawing during the surrender period will cost you a percentage of that withdrawal amount. Write down your free withdrawal percentage—the amount you can take each year without penalty.

How Taxes Work on Annuity Withdrawals

Taxes on annuity withdrawals depend on what type of account holds the annuity and whether the money was already taxed when you first contributed it. This is one of the most complicated parts of understanding annuities, but breaking it down into categories makes it clearer.

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Qualified Annuities (inside retirement accounts): If your annuity is held inside a 401(k), IRA, or similar retirement account, it's called "qualified." The money in qualified annuities was contributed with pre-tax dollars—meaning you didn't pay income taxes on it when you put it in. When you withdraw money from a qualified annuity, the full amount counts as regular income, and you owe income taxes at your ordinary tax rate. If you're in the 22% federal tax bracket, a $10,000 withdrawal means you'll owe approximately $2,200 in federal taxes (not counting state taxes and the 10% penalty if you're under 59½).

Non-qualified Annuities (outside retirement accounts): If you purchased an annuity with after-tax money (not in a retirement account), it's called "non-qualified." This is more favorable for taxes. The money you originally contributed—called the "basis"—was already taxed, so you don't pay taxes on it again when you withdraw it. Only the earnings (the money your investment made) get taxed. This "last-in, first-out" system means early withdrawals are taxed only on earnings, not on your full withdrawal amount.

Here's an example: You put $50,000 into a non-qualified annuity. Over several years, it grows to $75,000. The $50,000 is your basis, and the $25,000 is earnings. If you withdraw $30,000, only $5,000 of that is earnings (the part that gets taxed), while $25,000 is a return of your basis (tax-free).

Annuity Income (from payments, not lump-sum withdrawals): When you're receiving regular annuity payments as income (like $500 per month for life), a portion of each payment is a return of your basis (tax-free) and a portion is earnings (taxable). Your insurance company calculates this split using an IRS method called the "exclusion ratio." You receive a form each year showing how much of your payments was taxable income.

The tax rates you pay depend on your total income for the year and your tax bracket. State income taxes may also apply, depending on where you live. Some states don't tax retirement income at all, while others tax everything. Seven states (as of 2024) have no income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming.

Practical Takeaway: Determine whether your annuity is qualified (in a retirement account) or non-qualified (purchased with after-tax money). For qualified annuities, plan to owe income taxes on any withdrawal. For non-qualified annuities, ask your insurance company for an accounting of your basis (original investment) versus earnings. Keep tax records showing what you originally invested, as this protects you from being taxed twice.

Required Minimum Distributions and Age-Based Withdrawal Rules

The IRS doesn't let you keep money in certain types of annuities indefinitely without taking it out. Starting at age 73 (for those who turned 72 after December 31, 2022; the age was

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