Annuities are tax-deferred insurance contracts that provide you with immediate or deferred monthly income benefits. An annuity contract may last for several years or even for life. You can break an annuity contract in certain circumstances, although when you do so you may end up having to pay penalty fees and tax penalties.
When you buy a deferred annuity, the issuer invests your premiums in the market for a set number of years, after which you can withdraw your cash as a lump sum or convert it into an income stream. With variable annuities, your premiums are invested in mutual funds, while fixed annuity contracts contain interest generating accounts. Equity index annuities are tied to stock or bond indices. You typically have to pay surrender penalties if you cash in your contract before it reaches maturity with variable and indexed annuities. It can take up to 20 years for a contract to mature, and surrender penalties can amount to 25 percent of the contract's value. With a fixed annuity, you can often access your principal without penalty at any time, although surrender fees may wipe out your earnings.
You can buy an annuity with either pretax or after tax funds, but either way your contract grows on a tax-deferred basis. When you make a withdrawal you have to pay state and federal income tax on any portion of your money that has not been previously taxed. If you cash in your annuity prior to reaching the age of 59 1/2, you also have to pay a 10 percent federal tax penalty. You pay these taxes and penalties in addition to any applicable surrender fees.
Regardless of your age, you can break an annuity without paying taxes or tax penalties if you decide to roll your annuity proceeds into a new annuity or life insurance contract. The federal tax code includes a provision for the tax-sheltered movement of funds between insurance contracts. You do have to contend with contract surrender penalties, but if your contract has already matured, you can use the 1035 exchange rule to move your annuity cash without paying taxes or fees.
If you experience buyer's remorse after you sign on the dotted line you may have the option of cancelling your contract without incurring any fees. Many states have laws in place that provide annuity purchasers with a free look provision. The free look period lasts for between 10 and 30 days, and you can get your principal back without having to pay any surrender penalties if you choose to cancel the contract. However, you may have to pay taxes on any earnings that you made prior to cancelling the contract.
Immediate annuity contracts are generally irrevocable which means you cannot surrender your contract after the free look period ends. At that point, the issuer converts your lump sum premium into a monthly income source that may last for a set period of time or for life. In some states you can sell immediate annuity contracts on the secondary market. You arrange sale transactions through brokers who match up buyer's seeking income with seller's seeking a lump sum of cash. Laws on secondary market sales vary between states and some contracts include clauses that prevent resale.