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Annuity surrender charges
One of the first questions you should ask about an annuity is how long is the surrender charge period. A surrender charge period is a specified number of years that you have agreed to keep the annuity.
For instance, let’s say you are looking into purchasing an annuity with a 5% interest rate guaranteed over a period of 5 years. It would be likely to assume that you have a 5 year surrender charge period. However with some annuities you may have a rate guaranteed for 5 years but a 10 year surrender charge period. Insurance agents often like to sell products such as these because they pay a higher commission. That’s why it is always imperative to ask what the surrender charge period is on an annuity.
Many policies allow you to withdrawal a portion of your annuity funds with out a surrender charge. They call this a free withdrawal. Typically, these free withdrawals are 10%. Here is an example to help you fully understand the concept.
Jon is looking to purchase a $50,000 dollar annuity. He is buying a 5 year surrender charge annuity that offers a guaranteed 5% interest for all 5 years. The surrender charge schedule decreases over the course of 5 years. The surrender charge schedule is as follows…
- Year 1 = 10%
- Year 2 = 9%
- Year 3 = 8%
- Year 4 = 7%
- Year 5 = 6%
This product allows for 10% free withdrawals after the 1st year. That means if you need to take $5,000 from the annuity after only 6 months you would have to pay the insurance company $500 or 10%. This is the amount due as as surrender charge in the first year. That is of course if you are above age 59 1/2. If you are under 59 1/2 you may have to pay an additional IRS penalty. We will discuss this in later posts. Now let’s assume you don’t need any money from the annuity in the first year. Instead you need to take $5,000 from your annuity in the third year. Under this particular example you can take a free withdrawal from your annuity of $5,000 without incurring a surrender charge. That’s because this annuity offers a 10% penalty free withdrawal and 10% of $50,000 is $5,000.
Now lets discuss cashing in the policy early(before 5 years). You are in the third year of your annuity contract and you decide you want to put this money to work in the stock market instead. Therefore, you call the insurance company and tell them you want them to send you your money. They will charge you a surrender penalty according to the schedule above. Since you are in year three of your contract your charge is 8%. Your account balance is currently $55,125. That’s 5% interest over two years. Your annuity only credits interest on an annual basis. (We will discuss crediting in later posts) Your total refund at this point is going to be your account balance less your surrender charge percentage. We have illustrated the calculations below.
$55,125(account balance) * 8%(surrender charge) = $4, 410 ( amount you pay to the insurance company for removing the money before the end of your five year contractual agreement.
Total amount you will receive from the insurance company is $55,125 – $4,410 = $50, 715.00
To put this into perspective you only received a 1.5% return over 2+ years. You can see how surrender charges provide a source of income for the insurance companies. You can also see how important it is to know ahead of time exactly what your surrender charge period and surrender charge schedule is before purchasing an annuity.
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