Deferred annuity surrender and withdrawal charges…

Getting money out of a deferred annuity

A deferred annuity has two phases. During the accumulation phase the owner pays premiums and the contract builds an account value. During the payout phase the account is annuitized, meaning converted into an income stream. Most exam questions in this area ask what happens when money leaves the contract before annuitization: through a surrender, a withdrawal, a stop in premium payments, or the death of the owner or annuitant.

Surrenders and partial withdrawals

A full surrender cashes in the whole contract for its cash surrender value, and the contract ends. A partial withdrawal (also called a partial surrender) takes out only part of the account value and leaves the contract in force. Most accumulation annuities must allow access to contract funds this way at any time before annuitization.

Surrender charges

A surrender charge (or withdrawal charge) is a percentage penalty the insurer deducts when money is taken out early. It lets the insurer recover the acquisition costs, chiefly the producer's commission, that it paid up front.

The charge follows a declining schedule. A typical schedule starts around 7 percent in year one and falls by about a point a year until it reaches zero at the end of the surrender charge period.
On a flexible premium contract, each new premium may start its own schedule, so a later deposit can be locked up longer than the first one.
Most contracts include a free withdrawal provision. The owner may take a set amount each year, commonly 10 percent of the account value, with no surrender charge.
Many contracts also waive the charge on confinement to a nursing home or on a terminal illness diagnosis.
A bonus annuity credits extra interest in the first year, but it often pays for that bonus with a higher or longer surrender charge.
Replacing an annuity usually starts a brand-new surrender charge period on the new contract. That cost must be weighed before any exchange.

A surrender charge is the insurer's charge. It is entirely separate from the federal 10 percent tax penalty on withdrawals taken before age 59 and a half. Withdrawals from a non-qualified annuity are taxed earnings first, so the gain comes out, and is taxed as ordinary income, before any tax-free return of premium.

Nonforfeiture: the owner never loses everything

If the owner stops paying premiums, the contract does not lapse with nothing to show for it. The standard nonforfeiture law for annuities requires the contract to provide:

A paid-up annuity benefit: the value already built up keeps the contract in force as a smaller paid-up annuity, with no further premiums due.
A cash surrender benefit, if the contract allows lump-sum settlement, paid in lieu of the paid-up benefit.

These benefits must equal at least a guaranteed minimum value. Under the NAIC model law, that minimum is a stated percentage of premiums (87.5 percent) accumulated at a minimum guaranteed interest rate, less prior withdrawals. The insurer may defer paying a cash surrender for up to six months after the owner asks for it. That safeguard protects the insurer in a financial crisis, and in practice it is rarely used. The contract must disclose its basis for these values, and the owner receives a statement at least once a year showing the cash surrender, paid-up and death benefit values.

Variable annuities and immediate annuities are outside this nonforfeiture law. A variable annuity's value rises and falls with its separate account, and an immediate annuity has no accumulation phase to protect.

A two-part diagram. On the left, a bar chart shows a typical deferred annuity surrender charge schedule. The charge is 7 percent in year one, then 6, 5, 4, 3, 2 and 1 percent in years two through seven, and zero from year eight. A band beneath the chart notes that about 10 percent of the account value can be withdrawn each year with no charge. On the right, three boxes show the ways money leaves a deferred annuity before payout. The first box, a surrender or withdrawal, is subject to the surrender charge, plus a separate 10 percent tax penalty before age 59 and a half. The second box, premiums stopping, triggers nonforfeiture benefits: a paid-up annuity or a cash surrender with a guaranteed minimum value. The third box, death before annuitization, pays the greater of the account value or premiums paid, with no surrender charge. — A declining surrender charge schedule, and how surrender, stopping premiums and death are each treated before annuitization

Death benefits

If the owner or annuitant dies before annuitization, the contract pays a death benefit to the beneficiary.

The typical guaranteed death benefit is the greater of the account value or the premiums paid, less any withdrawals.
Many variable annuities offer an enhanced benefit, such as the highest anniversary value.
A death benefit is not a surrender. Surrender charges generally do not apply to it.
A surviving spouse beneficiary can usually continue the contract as the new owner. Other beneficiaries must take the money out within a set period.
The beneficiary owes ordinary income tax on the gain. Unlike life insurance proceeds, annuity gains get no step-up in basis.

After annuitization, any death benefit depends entirely on the payout option chosen. A straight life annuity pays nothing more at death. A period certain or refund option continues payments, or pays a refund, to the beneficiary.

Exam tip: a surrender charge is a contract charge that declines to zero over time. The 10 percent penalty before age 59 and a half is a tax rule. A death benefit escapes the first and is not subject to the second.

Deferred annuity surrender and withdrawal charges, nonforfeiture, and death benefits