Annuities and mutual funds are two different products. Annuities are contracts with an insurance company. Think of them as a luxury sedan: You pay them a premium and they guarantee you a future stream of income. Insurance companies calculate, and offer guarantees on, that stream of income in different ways. The guarantees function like shock absorbers, taking the sting out of market risk -- but at a cost. Mutual funds, on the other hand, are more like race cars: They are designed to make money, but there are no guarantees on a mutual fund. Understand what you are transferring into if you sell an annuity to buy a mutual fund.
Tax Consequences of Selling an Annuity
If you sell an annuity outside of a retirement account, such as an IRA, you will have to pay taxes on any profits, and you don't get the favorable long-term capital gains treatment. The IRS considers any profits on selling an annuity to be income. Subtract your tax basis -- the total amount of after-tax dollars you contributed to the annuity -- from the annuity's surrender value. The difference is the amount you will have to pay income tax on.
Surrender Charges and Penalties
Your annuity may levy a surrender charge if you bought it within the last several years. Surrender charges may last for as little as three years from purchase, or as long as 13 years, depending on the contract. This is one reason why you might want to wait before selling your annuity to buy a mutual fund. If you are under age 59 1/2, you may have to pay an additional 10 percent early withdrawal penalty on the annuity.
The law allows you to defer taxes when you sell one annuity to buy another annuity, under IRC Section 1035. You don't get this advantage, however, when you sell an annuity to buy a mutual fund. Consider this carefully before selling an annuity to buy mutual funds or any other financial product.
Transfers In Retirement Accounts
If you own your annuity in a tax-deferred retirement account and you cash it out, you will have to pay income taxes on the whole balance unless you made nondeductible contributions. This is because you have no tax basis in the annuity. Your tax basis consists only of after-tax contributions you paid. However, if you sell the annuity and buy the mutual fund, all within a retirement account, such as an IRA, you will not have an immediate income tax liability. However, surrender charges and early withdrawal penalties may still apply.
You may not be able to sell an immediate annuity or any annuity once it has already begun to dispense income. Remember, the annuity is just a contract. You own no other assets to sell other than the agreement, though the insurance company may be willing to settle the stream of income for a lump sum. See your individual annuity contract for details, or contact your agent for specific information regarding the annuity you own and buyout provisions.
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.