By Marc Gilman
Questions? Call (800) 927-9326 or email
Key Takeaways
-
Before deciding anything, find out two things: is it qualified or non-qualified, and what type of annuity is it. Those two facts determine which options are even available to you.
-
Annuity withdrawals are taxed earnings-first. Unlike a lot of other accounts, you don’t get your original contribution back tax-free until every dollar of gain has already been withdrawn and taxed as ordinary income.
-
If you’re under 59½, a 10% IRS penalty typically applies to the taxable portion of any withdrawal — on top of ordinary income tax, with only narrow exceptions.
-
“They’ll pay me 7%” almost never means a 7% rate of return. That’s usually a payout rate or a guaranteed withdrawal benefit rate — a very different number that can represent your own money coming back to you for over a decade before any actual gain shows up.
-
A 1035 exchange defers taxes, but it also restarts the clock. Moving an old annuity into a new one is treated as a brand-new purchase, with a brand-new surrender period attached.
Step One: Qualified or Non-Qualified?
This is the first fork in the road, and it determines how much flexibility you actually have.
Qualified means the annuity was funded with pre-tax dollars — often inside an IRA or a retirement plan. Money in a qualified annuity can generally be rolled directly into an IRA, at which point you’re no longer limited to the annuity’s investment menu at all — the funds could go into stocks, bonds, mutual funds, or ETFs while keeping their tax-deferred status.
Non-qualified means it was funded with after-tax money. Your options for preserving tax deferral are narrower here — largely limited to a 1035 exchange into another annuity, discussed below.
Step Two: What Type of Annuity Do You Actually Have?
Old paperwork uses a lot of similar-sounding names, and the type matters for what you can do next:
-
Immediate annuity — you already handed over a lump sum in exchange for a payment stream. If income has already started, there’s typically nothing left to change. The one exception is a very recent purchase still inside its state-mandated “free look” period (commonly 10 to 30 days), during which you can cancel and get your money back.
-
Fixed annuity — a set interest rate, often guaranteed not to fall below a stated minimum.
-
Multi-Year Guaranteed Annuity (MYGA) — similar to a CD, but tax-deferred: a locked interest rate for a set number of years.
-
Fixed-Indexed Annuity (FIA) — returns tied to a market index, typically with a 0% floor (so you don’t lose money in a down year) but also a cap or participation rate that limits your upside. Worth knowing: FIA index returns generally exclude dividends, which can meaningfully understate what the index “actually did.”
-
Variable annuity — invests in a menu of underlying funds, similar to a 401(k), but often carries higher ongoing costs — mortality and expense charges, fund expenses, and rider fees that can push total costs above 2% a year.
How Annuity Withdrawals Are Actually Taxed
This surprises people who are used to how other accounts work: annuity withdrawals are taxed earnings-first. If you put in $50,000 and the annuity is now worth $100,000, the first dollars you withdraw are treated as the $50,000 of gain — taxed as ordinary income — before you ever touch your original $50,000 tax-free. This applies whether you take a lump sum or a series of smaller withdrawals over time.
If you’re under 59½, the IRS generally adds a 10% penalty on top of ordinary income tax for the taxable portion of a withdrawal, with only limited exceptions (death, disability, and a few specific payment structures).
Your Real Options
Cash It Out
If the annuity no longer serves its original purpose, cashing out is straightforward — but get the full picture first: your cost basis, current value, any surrender charges, and how the taxable gain would affect your tax bracket for the year. A large enough gain can also affect other things tied to income, including the Net Investment Income Tax and Medicare’s IRMAA surcharge on Part B and Part D premiums.
Withdraw Gradually
Many contracts allow a penalty-free withdrawal each year — often around 10% of the value — even during a surrender period. The tax treatment is the same earnings-first rule: your early withdrawals count as taxable gain until the gain is exhausted, after which the remaining withdrawals are your own tax-free basis.
Annuitize It
Converting the balance into a monthly income stream can make sense — but only for the right reasons. Worth asking yourself honestly: do you actually need this income, or does Social Security, a pension, and other assets already cover your needs? Are you specifically worried about outliving your money?
Two things trip people up here. First, a payout rate is not a rate of return — if an insurer says a rider will “pay 7%,” that’s usually calculated against your original contribution, not a return on it. Handing over $100,000 for $7,000 a year means you’re receiving your own money back for roughly the first 14 years before any actual gain appears. Second, annuitizing is generally irrevocable — once converted, that money is no longer available as an inheritance or a lump sum for an emergency, and most annuitized income streams don’t adjust for inflation unless you’ve specifically paid for that feature (often at a meaningfully lower starting payment).
1035 Exchange to a New Annuity
A 1035 exchange lets you move the full value into a new annuity contract without triggering the tax on the gain — genuinely useful if the new contract offers better rates or features (a long-term care rider, for example) that fit your situation better today.
The catch: a 1035 exchange is treated as a brand-new purchase. Even if you’re past your old surrender period, the new contract starts its own — often six to ten years. It’s also worth asking directly whether the exchange is being recommended because it’s genuinely the better fit, since a new annuity purchase typically means a new commission for whoever sells it to you.
Keep It As-Is
Sometimes none of the above make sense right now — the tax bracket is wrong for cashing out, a 1035 exchange doesn’t improve your terms, and annuitizing doesn’t fit your income picture. That’s a legitimate answer, but it shouldn’t be a passive one: check that any optional riders or investment sub-accounts are still set the way you’d choose today, and put a specific date on the calendar to revisit it — not “someday.”
Questions Worth Asking
-
Do you know whether your annuity is qualified or non-qualified, and does that change what you could do with it?
-
Have you asked the insurer for your current cost basis, market value, and any applicable surrender charges?
-
If someone has quoted you a percentage on this annuity, do you know whether that’s an actual rate of return or a payout/withdrawal rate?
-
If a 1035 exchange has been suggested, have you compared what the new contract’s surrender period and terms would actually be?
What To Do Next
If you have an old annuity you haven’t looked at in years, let’s pull the actual contract details together — cost basis, current value, surrender terms, and how it fits your broader plan — before you decide anything.
Questions? Call (800) 927-9326 or email
Prefer we reach out to you instead? Complete our Permission to Contact form and a licensed Gilman Agency agent will follow up.
Sources: Internal Revenue Service, Section 1035 exchange guidance and annuity taxation rules (IRC Section 72); Centers for Medicare & Medicaid Services, Income-Related Monthly Adjustment Amount (IRMAA) guidance; general annuity contract structures and industry practice regarding qualified/non-qualified status, free-look periods, and annuitization mechanics.
This article is for general educational purposes and reflects common annuity contract structures. Specific terms, tax treatment, surrender schedules, and options vary by contract, carrier, and individual circumstances — always review your actual policy documents and confirm current details directly with your carrier or tax advisor. This is not a recommendation regarding any specific product, and is not tax or legal advice. Consult a licensed advisor for guidance specific to your situation.
