By Justin Pritchard, CFP®
Note: This is a long article! If you’d rather hear me talk through this information, click here for a YouTube video (audio only, so you can listen while you’re doing other things).
Annuities are complicated: You can’t see how they work behind the scenes, but you receive promises and guarantees from an insurance company. But sales presentations may not completely explain how things work, and you might think of questions after you’re finished meeting with an insurance agent.
With a significant portion of your savings at stake, it’s critical to understand how things work. I often help clients evaluate whether or not to get an annuity, and we also explore alternatives when they’re stuck in less-than-perfect annuity products.
Some key concepts revolve around the money you contribute to an annuity:
- When you put money in an annuity, can you get it back (your principal investment)?
- What happens to the funds in an annuity when you die?
- What if you change your mind or need to do something else with that money?
- Does the insurance company keep your principal investment?
As with most financial topics, there are no simple yes or no answers, but it’s not too complicated. Here’s an overview, and we’ll cover all of the details farther down:
- Deferred? In some cases, particularly with deferred annuities, you can take your principal back (at death, or whenever you feel like it). But read on.
- Surrender charges: You might have to pay surrender charges for cashing out. That means the insurance company keeps a percentage of your withdrawal, and you might receive substantially less than you put in (or less than your account balance). Ultimately, you end up with less money to spend.
- Lifetime income? If you arranged a lifetime series of payments, you (or your heirs) might not receive anything after death unless you used something like a “period certain” or refund option.
- Flexible income: Income “riders” can allow you to stop income and cash out, but you might not have any assets left to walk away with.
- Taxes: You may owe taxes on any withdrawals you take, effectively reducing the amount left for spending.
We’ll cover the most common situations below, starting with the most flexible. Ultimately, your flexibility depends on the type of annuity you have and how you set things up. But remember that flexibility comes with tradeoffs, and it’s not always best to structure an annuity so that you get a refund.
Example 1: Deferred Annuities
In its most flexible form, an annuity is just an account with certain features. It’s similar to other accounts you might invest in, but it’s not the same as a standard taxable investment account or a bank account.
An annuity is an insurance contract. As a result, tax rules may dictate how you get money in and out of the account. Insurance companies can also set restrictions on how and when you take your money out. For an overview of the basics, see this primer on annuities.
Transfers and withdrawals: With a deferred fixed or variable annuity (assuming it is not an immediate annuity or a longevity annuity), you can often get your principal back at any time. Just like with any other account, you can request one of two things:
- That the investment provider cash you out by sending a check for your remaining account balance after any transaction fees
- A transfer of assets to a similar account somewhere else, potentially without tax consequences
1035 exchanges may allow you to transfer assets from one insurance contract to another without triggering tax consequences. But it’s critical to get the details right, and you may still have to pay fees to the insurance company.
Sometimes I help clients move from high-cost annuities to no-load annuities with a 1035 exchange, but it’s critical to review the details carefully before you go that route.
But should you? Just because you can cash out doesn’t mean it’s painless. You may have to pay income taxes, tax penalties, a variety of fees, and — perhaps most importantly — hefty surrender charges. Annuities, like other things in life, are easy to get into and (sometimes) hard to get out of. That doesn’t mean they’re always wrong or bad, but you need to clearly understand the pros and cons before signing up for one.
Surrender charges can last as long as 20 years, and you may have to pay up to 20% of the amount you withdraw. So please check carefully before you take action. You should be able to find surrender information on your statements.
How to find out: How do you know if you can withdraw funds from your annuity? The easiest way to find out is to ask. Call the insurance company and get the details. If you’re thinking of purchasing an annuity, ask the insurance agent who’s selling the product what your options will be (as well as what it’ll cost, and when you’ll have those options). If you don’t trust the answers you receive, contact the insurance company directly. Phone support reps are typically up-to-speed on the products, and they know more than salespeople.
Example 2: Income From “Living Benefits”
What if you started taking some kind of income from your annuity? Will you get your principal back?
Again, it depends.
Partial, on-demand withdrawals: If your source of income consists of you calling the insurance company whenever you need money, there’s a good chance that you can walk away with your principal whenever you want. Instead of calling and asking for a little bit, you can ask for the entire amount. Alternatively, you can have the entire amount transferred to another account or annuity if you just want to switch investment providers.
Income riders: If you’re receiving income as part of a “rider” or “living benefit,” you may have some flexibility. Examples of this approach include lifetime income that’s a percentage of your account value (whether it’s your real account value or a hypothetical account value). For example, the insurance company might promise to pay you 5% of your account value for the rest of your life, starting at age 65.
If you’re using a rider, you can often walk away with your remaining principal at any time (after paying any surrender charges, taxes, and other charges). The value of your principal might have increased or decreased — it typically decreases when you take income from the account — but you can take whatever remains in a lump-sum, if you wish.
Before taking a withdrawal, find out how much you’ll get versus how much guaranteed income you’re giving up. In some cases, you’re better off leaving the money where it is (especially if you’ve suffered large losses in the markets and your money is with a strong insurance company). In extreme cases, you can deplete your principal, but the insurer might continue to pay income, so proceed with caution.
Example 3: You Annuitized
A rider offers guaranteed income for life, but it’s not the traditional way to get lifetime income from an annuity. The classic way to use an annuity for retirement is to invest a lump sum in exchange for a guaranteed stream of payments that continues for the rest of your life — however long that may be. Alternatively, you can specify a certain number of years to receive income, regardless of how long you live. This is called annuitizing.
Annuitize vs. living benefits: How is annuitizing different from the riders described above? When you annuitize, you get a bigger payment because there are no “takebacks” — you can’t change your mind. Technically, you can get cash for your annuity payments, but it’s a difficult process, and you’d have to find somebody besides the insurance company to buy your future stream of payments from you. In contrast, with a living benefit or rider, you can walk away with your remaining account balance (after any charges) at any time.
The largest payments: When you annuitize, you typically get a larger payment than you’d receive with a rider (all other things being equal). You make an irrevocable decision, so the insurance company doesn’t need to worry about you calling next month to withdraw all of your money. Optional features can also affect how large your payment is (income for your lifetime only, your lifetime plus your spouse’s, a 10-year “period certain,” etc.). When couples plan for retirement, it’s crucial to consider how women’s longevity affects retirement.
What happens to the principal when you die? That brings us to the question on everybody’s mind: What if I annuitize and die next month? Then do we get any of the principal back from the annuity? Unfortunately, the answer is still not simple. It depends on which options you selected when you bought the annuity.
- Simple lifetime payout: If you choose a straight lifetime payout based on one individual’s life, the payments end when the annuitant dies (that’s usually you or whoever owns the annuity). In other words, when you choose a single life payment, you and your heirs do not get your principal back when you die. That option provides for the largest annual or monthly payments because you’re taking a substantial risk.
- Joint (and survivor) lifetime payout: As long as one of the people on the annuity is still alive, the insurance company continues to pay. The payment might decrease after the first person dies, or it might not. Either way, you continue receiving payments until the second person dies. After that, there are no more payments, and you would not receive a refund of your principal unless you added optional features.
- Lifetime payout with period certain: If you find the scenarios above troubling, you can add a “period certain” to your payout. With that option, the annuity will pay out for at least as long as the period certain (or for your lifetime, whichever is longer). A typical period certain might be 10 or 15 years. Your beneficiary will receive payments if you die before the term is up, so your family will likely get some of your principal back. But in exchange, you receive smaller payments than you’d get from a straight lifetime annuity.
- Lifetime with refund: A “refund” option can also protect against early death. When you die before getting all of your principal back, the insurance company pays the difference to your beneficiaries. Of course, this means you get smaller payments (there are always tradeoffs with financial products).
- Period certain only: You can also choose to get payments for a set number of years, and those payments end after the period certain term — even if you’re still alive. You (or your beneficiaries) will generally get your money back because the insurance company is not basing the payments on your life expectancy. Instead, they know they need to pay it all back over a certain number of years, and they’ll earn a profit while holding your funds.
If you’re considering an annuity, you may appreciate this complimentary 5-page report on the 6 Safest Investments for wild markets (including common misconceptions). It makes sense that you’re interested in the guarantees that come with annuities — investing can be scary! So it’s worth educating yourself before you lock up your money. Sometimes commissioned salespeople don’t explain this stuff to you. And even when they have good intentions, they might not completely understand the products they’re selling.
Important Information
Please do not rely solely on this article when deciding what to do about an annuity. This is just general educational content written for a broad audience — not you in particular. Every contract is different, things change over time, and this article might not be accurate or applicable to your individual circ*mstances. Read through all materials from your insurance company, ask questions, and educate yourself on what you have available to you. Contact the insurance company directly and request written disclosures instead of relying on anybody’s statements.
