How To Get Out of an Annuity - Exchange It or Surrender It

Consider taxes before deciding to surrender or exchange a variable annuity.

Couple reading the annuity contract papers.
You can get out of an annuity. But read the fine print first. Sam Edwards/Getty Images

There are several ways to get out of an annuity.

  1. If it is an IRA, you can roll it over, or transfer it.
  2. If it is not an IRA you can use a 1035 exchange, or surrender it.
  3. If it is an income annuity, you have to find someone to buy you out.

Options one and two above apply to annuities that are not yet paying out a monthly income. Option three applies if the annuity is paying out income. Here's how each of these options work.

1. Getting Out of an Annuity When It's an IRA or Retirement Account

If you have a variable annuity that is owned inside of an IRA account you can simply roll your funds out of the variable annuity and into a regular IRA at a bank, mutual fund company, or brokerage firm. Since the funds are still inside of the IRA wrapper, it is considered a transfer or rollover, and no taxes are due on such a transaction. Be aware, some annuities have surrender charges that can last up to fifteen years from your purchase date. Before you cancel or exchange any variable annuity, check on any fees that may be applied. If the surrender charges are high, but will be lower in a few years, it may be best to wait a few years before rolling over your IRA annuity to a different account.

Assuming there are no surrender charges, or they are quite low (2% or less) then in many cases by moving a variable annuity inside of an IRA to a portfolio of index funds, you can reduce your expenses from 2% - 3.75% per year down to .50% - 1% a year.

These lower ongoing fees can result in significant savings over time. If you are able to reduce fees by 2% a year on a $100,000 investment. You will save well over $20,000 over a ten year time frame.

2. Getting Out of an Annuity That is NOT an IRA

If you own a variable annuity that is not inside of an IRA or another type of retirement account such as a 403(b), before you cancel the annuity, for tax purposes, you will need to find out if your annuity has a gain or a loss.

 To do this, first, you will need to know your annuity’s cost basis. The cost basis is the total amount of money you put into the annuity. If you don’t know the cost basis, call the customer service number on your statement and ask. Next, compare your cost basis to the current value of your variable annuity.

If there is a gain - If your annuity has a gain, and you cash in the annuity, you will pay ordinary income taxes on any gain. If there is a large gain in your annuity, instead of cashing in the annuity, you can exchange it (called a 1035 exchange) for a no-load variable annuity that has lower expenses. Vanguard, for example, offers such a low fee annuity. If your annuity has a minimal gain, you may wish to cash in the annuity and use the funds to invest in other lower cost alternatives by opening a mutual fund or brokerage account.

If there is a loss - If you the current value of your variable annuity is lower than the cost basis, you have a loss. If you cancel the annuity, you may be able to claim that loss on your tax return. Be cautious of canceling a variable annuity that has a loss, as in these cases the death benefit on the annuity may be at least equal to your cost basis, so by canceling the annuity, you would be foregoing some level of death benefit.

3. Getting Out of an Income Annuity

An income annuity is an annuity that is paying out a monthly benefit to you. This type of annuity can be difficult to get out of. You have to find someone to estimate what the ongoing stream of payments is worth, and offer you a lump sum. This is referred to as a structured settlement. Consumer Affairs offers a list of the best companies to contact to buy out your annuity. Contact several before deciding on an offer.

Other Things to Consider

Annuities are a contract with an insurance company. Some annuities guarantee a particular level of retirement income. Be sure you understand all the guarantees before you get out of an annuity. You could be cancelling an insurance benefit that you would not be able to replace. If you understand the benefits, and they are not valuable to you, then getting out of your annuity is likely your best course of action.