When you invest in an annuity, you aren't locked in. You can end the contract early and take your money out with a withdrawal. When you take a withdrawal, through, the IRS will charge tax on some part of the money. You could also get hit with extra fees on top of the income tax for ending your contract.
If you funded your annuity with pretax money, taking it out will create taxable income. This happens when you roll over a retirement plan like a 401(k) or an IRA into an annuity, or if you invested in an annuity in a qualified retirement plan at work, such as a 457 or 403(b) plan. The annuity continues to delay taxes on this income until it is paid out to you. Since you never paid income tax on your investment contributions, you will owe this tax when you take the money out of your annuity.
When you put money in an annuity after you paid taxes on it, it invests and grows your savings tax-free until you withdraw it. Fixed annuities pay a guaranteed rate of return on your money, while variable annuities invest your savings in the stock market. You don't need to pay tax on your investment gains while they stay in the annuity contract. But when you take your gains out through a withdrawal, they will count as taxable income.
The IRS doesn't double-tax your annuity contributions. If you invested after-tax money in your policy, you get this money back tax-free in a withdrawal.
When you make a partial annuity withdrawal, you only take out some of your annuity money. The IRS taxes partial annuity withdrawals as "Last In, First Out." This means that your before-tax annuity money comes out before your after-tax contributions. Only once you've taken out the entire taxable part of your annuity can you start making withdrawals from the nontaxable part.
The annuity has the same early withdrawal penalty as a retirement account. If you withdraw money before you turn 59 1/2, the IRS charges an extra 10 percent fee on your investment earnings and your pretax contributions. The penalty doesn't apply to your after-tax contributions. In addition, your annuity company could charge you a fee for taking out your money. Annuity companies typically charge a surrender charge when you take out money within the first five to seven years of your contract.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.