Colin Gerrety, CFP®, CIMA®

Colin Gerrety, CFP®, CIMA®

Colin equates success with helping others make good decisions. A DC-area native, Colin works closely with our client families to navigate the complexity of today's financial world.

In my recent article, I discussed some of the common drawbacks of variable annuities.  The hefty fees, misleading guarantees, and tax treatment can put investors in an uncomfortable spot.

But what do you do if you own a variable annuity and have buyer’s remorse?  There are a few options to get out of a bad variable annuity.

Take the money and run

One option to get out of a bad variable annuity is simply to terminate the contract.  Yes, you can cash out.  But beware: cashing out of an annuity can have tax consequences and surrender charges, and you may miss out on potential benefits, depending on the annuity contract and your personal situation.

When considering cashing out of a non-qualified annuity (meaning one that isn’t held in an IRA), you’ll want to look at the “cost basis” of your annuity vs. the cash value today.  The difference is generally subject to ordinary income tax, and may be subject to an additional 10% tax penalty if you’re under 59 ½. You’ll also want to consider any surrender charges and when those surrender charges end.  Most commission-based variable annuities come with a “surrender period,” during which you pay a penalty to withdraw money, and the surrender charge can be hefty, even up to 10% or more in some cases but declining over time.  These surrender charges typically exist to compensate for the broker’s up-front commission check.

Pro tip: some annuities may come with a “free look” period, lasting a handful of days, in which you can terminate your annuity without any surrender charge.

It’s also a good idea to review the annuity contract in depth to see what benefits you may be losing by cashing out.  Many of the bells and whistles of annuities end up costing more than they’re worth, but some can be valuable depending on your situation.  For example, an 85-year-old client in poor health with a variable annuity with a death benefit of $500,000 but a contract value of $400,000 may be better off keeping their annuity than terminating it, even if there aren’t tax consequences or surrender charges.  Unfortunately, annuity contracts tend to be complex, so it’s a good idea to have a professional – one who doesn’t earn a commission on product sales – review your contract before making any changes.

1035 Exchange or Rollover

The IRS, under Section 1035 of the tax code, may allow you to exchange one annuity contract for another.  This “rescue” strategy can allow you to defer taxes while switching to a lower-cost contract.  Investors may therefore exchange variable annuities when they don’t have a surrender charge on their existing annuity, but cashing out the annuity would result in a large tax bill.  In that case, it can make sense to exchange the annuity to a lower cost contract through a different provider that has significantly lower fees than other annuity companies, no commissions, and no surrender charges.  As a note of caution, you’ll want to confirm there won’t be any surrender fees or tax implications by exchanging your current contract.  Annuity contracts are complex, so consult a tax professional before making any changes.

For variable annuities held inside an IRA (“qualified” annuities), it’s normally possible to terminate the annuity and rollover the proceeds into a traditional IRA, which allows you to invest in all sorts of lower-cost investments, like index funds, ETFs, or regular old stocks and bonds.  However, you should confirm if there’s a surrender charge for terminating your annuity contract, and weigh the pros and cons of any guarantees your current contract offers before making any changes.

Annuitize or Withdraw Over Time

Annuitization trades the value of your variable annuity for a stream of income payments from the insurance company, which can be fixed or fluctuate with investment performance.  These payments typically last for your lifetime or a fixed number of years and may carry a survivorship option, through which your surviving spouse or beneficiary would continue to receive income payments for a period.

Annuitization may be a good option mathematically if you expect to outlive your projected lifespan.  However, the term used by many annuity companies, “lifetime income,” is somewhat of a misnomer because unless you live for a long time, the value you receive in “income” may not exceed what you purchased the annuity for in the first place!  It’s also worth noting that by annuitizing, you typically give up the right to withdraw any more than your periodic income payment and may lose any associated death benefit as well.

One option that may make sense, depending on the annuity’s value and guarantees, is to make systematic withdrawals from the annuity rather than annuitizing.  For example, some annuities carry a “Guaranteed Lifetime Withdrawal Benefit” rider, through which you can make periodic withdrawals of a certain amount (e.g. 5% of the “benefit base” per year).  Although these riders typically carry a substantial annual cost, if the value of the underlying investments have done poorly, the income base may be worth more than the contract value.  If it doesn’t make sense to cash out or exchange the annuity, it may make sense to take systematic withdrawals each year.  Depending on the contract and how long you live, this “income” may not exceed what you purchased the annuity for in the first place, but at least if you die in the interim, your heirs may inherit the contract value or death benefit.  A qualified financial planner can help you do the math.

The bottom line is that variable annuities can be costly and complex.  In my experience, most individuals are better served in simpler, lower-cost investments.  And although getting out of a bad variable annuity can be difficult, it’s crucial to get to know your contract in detail.  You may be better off as a result.

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