By Tom Rasmussen, CFP®
If you are wondering how to get out of a bad annuity, you have options. Keep in mind that when the proper annuity is selected and used effectively, it can be a great tool in your financial plan and in helping to generate income at retirement. Conversely, when preyed upon by an advisor, or insurance agent, individuals can get stuck in annuity products that are not the best for their situation.
Once stuck in one of these annuities, it can be difficult and expensive to get out of it. We will go over some of your options if you own an annuity that is “bad” or unneeded.
What Is an Annuity?
I will start by briefly describing what an annuity is. In short, annuities are contracts between you (as the purchaser) and the insurance company. You agree to pay the insurance company either a large lump-sum amount up front or a series of payments, like insurance premiums.
In return, they promise to pay you a series of regular payments, often monthly. The payments last for either your lifetime or a determined period that is agreed upon in the contract.
These periodic payments can start immediately or at some point in the future. That is determined by the type of contract you purchase. Income received from annuities is typically taxed as ordinary income. There is much more to annuity products than this brief explanation.
Options to Get Out of an Annuity
Should you be stuck in an annuity that you no longer want, you have options. As with anything insurance-related, some of the options are cheaper or easier than others.
Listed below are a few of your options. As with anything, this is not to be considered a comprehensive list.
Free-look period: The free-look period is your window of time in which you can back out of the contract without any additional fees or charges. This period allows you to cancel should you change your mind about the annuity once you have had time to think it over.
The free-look period is typically restricted to about 30 days for most insurance companies. Once the free-look period has closed, you cannot cancel the contract without penalties and charges.
Return-of-premium rider: As with all insurance-based products, annuities can have riders included for an additional expense. The return-of-premium rider is a safeguard that you put into place during the purchasing process. The rider, as it suggests, allows you to request that any premium paid be returned to you, effectively canceling the annuity.
1035 exchange: This is not to be confused with a 1031 exchange, which is used for real estate. If you still want to own an annuity—just not the one you purchased—you can do what is called a 1035 exchange.
A 1035 exchange allows you to switch your annuity for a new product without any tax consequence. By doing a direct switch, you effectively defer any income taxes that you otherwise would have paid.
Keep in mind that in exchanging annuity contracts, you also restart the surrender schedule (more on that below). One thing to note is that if your annuity is a qualified (IRA) annuity, you can roll those funds tax-free into a regular brokerage IRA.
Surrender annuity: If you want out of an annuity completely, you can surrender it. This means you cash out the value of the annuity, including the accumulated growth.
Before you surrender your annuity, you should consider the consequences. First, you should understand the taxation, which will be determined by the type of annuity (i.e., non-qualified or qualified). Surrendering an annuity may lead to an unnecessary tax bill.
In addition to taxes, you should consider the surrender schedule. Surrender schedules can typically vary between five and 10 years. Each year that you hold the annuity during the surrender period, the surrender fee goes down.
As an example, in the first year, the surrender fee may be 2% and drop 0.25% each year until you are “out of surrender.” At that point, you may surrender the annuity without the fee.
Before deciding on any one of the above options, you will want to consider all possible fees and tax consequences.
Please note that this is not a post to talk you out of an annuity. Just as with any product or tool in financial planning, annuities have their place. Should you find yourself in a bad situation, these are some of your available options to get out of it.
Schedule a complimentary meeting with a wealth advisor to discuss your personal situation.