One of the chief criticisms of annuities is their relative lack of liquidity. This is true in some respects. Annuity owners give up complete liquidity in exchange for other benefits, including insurer guarantees for lifetime income, guaranteed growth, or protection from downside risk.
Many annuities now come with guaranteed income riders that can be turned off and on while letting you still access at least some principal. And most contracts do offer something called "free withdrawals."
What is a Free Withdrawal?
A free withdrawal is a payment you can take out of your annuity without having to pay a penalty, or a surrender charge, as the insurance company calls it. In most cases this free withdrawal amount will be equal to a given percentage of your annuity's accumulation value each year, such as 5% or 10%.
If you withdraw more than this amount in a given year, then you will have to pay a back-end surrender charge on the excess amount.
So, say your contract allows you to withdraw 5% per year and you withdraw 7%. Then you will have to pay a surrender charge on the excess 2%.
Of course, you will generally have to pay taxes on the amount you withdraw. Since annuities are intended as retirement savings vehicles, you might also face a 10% early withdrawal penalty on any money you take out before age 59.5.
What is the Most You Can Take Out with an Annuity Free Withdrawal?
Most fixed annuity contracts allow free withdrawals of up to 10%. However, a number of MYGA contracts limit their free withdrawals to 5% of the contract value each year.
This is in return for the superior interest rates that they pay. Be sure to check the details of any annuity that you are considering before signing on the dotted line, particularly if it's a MYGA.
Many annuity contracts allow as much as a 10% free withdrawal in Year 1 of your contract. Some others have a vesting schedule that requires you to wait for a year or two before you have that option for liquidity.
Again, checking the contracts of interest for specific details is paramount. Don't buy any annuity before you do this.
How Long Does the Insurance Company Apply Free Withdrawal Limits for?
The free withdrawal provision applies only during the surrender period for the annuity. Many surrender periods for fixed-type annuities tend to last in the 3-10 year range.
However, some do go for longer than that. For example, some insurance companies have annuity product selections with back-end surrender charge schedules as long as 15 years.
This reinforces how important it is to look at the contract before you buy your annuity. While the contract review may be an extra step, the good news is it lets you know exactly what you are receiving with that contract.
Why Do Annuities Have Free Withdrawals?
Why do annuity insurance companies have "levers" such as surrender periods and free withdrawal provisions at their disposal? Aside from solidifying their position to make money and thus keep their contractual promises to you, there are a few other reasons:
1. To prevent "runs" on money in annuity policies. Think of the bank runs of the early twentieth century. While we aren't likely to see this sort of activity again\, it could be tempting for policyholders to pull all of their money out of their annuity contracts if times got hard enough.
2. Insurance companies are required to keep dollar-for-dollar reserves in cash and cash-equivalent holdings for each dollar of annuity premium they receive. The bulk of annuity dollars are put into medium-term to long-term investments such as bonds and Treasuries.
That makes necessary an investment and time horizon structure for that investment to work, as the insurer covers its obligations to you with that underlying investment.
When you pull out money from your contract, the efficiency and performance of these investments is disrupted. Hence, withdrawal provisions and surrender periods are ways for the insurer to maintain its responsibilities to you as a policyholder.
3. With the risk pooled across thousands of policyholders\, these levers also help protect your annuity policy against others also surrendering their contracts in the same manner.The resulting financial stability is that the insurance company is able to offer a quite-dependable fixed-income asset in fixed-type annuities to you and other policyholders. That assurance is for now and years to come.
4. The back-end surrender schedule is also to deter annuity owners from cashing in their contracts before they reach retirement age.
As mentioned previously, annuities are under the law as retirement savings vehicles. So they are constructed to discourage early withdrawals of any type. Ordinary income taxes will apply to all of your withdrawals regardless of whether you are 59.5 or not, plus the 10% early withdrawal penalty if you aren't.
This can amount to a total assessment of 30% of your withdrawal in some cases, especially if you are in a higher tax bracket. And this will apply even if your annuity is in a Roth IRA. So, try to avoid doing this if at all possible.
What If You Need Money in General from Your Contract?
If you do need money from your annuity, a prudent course would be to keep it to the free withdrawal amount. That way you minimize costs.
If you have an emergency health situation, many annuities have provisions allowing you to access your money as well. Read your contract and check with your financial professional for more details in this area.
Some Novelty Options for Free Withdrawal Provisions
Annuity free withdrawals are ultimately a way that people can access at least some of the money in their contracts. But they are limited to a relatively small percent of the contract accumulation value.
Some contracts allow you to withdraw a higher percentage, if you don't touch the money in the contract for a certain amount of years.
For example, some insurance companies permit what they call a "cumulative free withdrawal" if you don't take money out for the first few years. Cumulative free withdrawals can be as high as 30% of your contract value.
Some insurance companies also offer a "liquidity rider." In this case, they let you take out more than the standard free withdrawal for a year. Many of these contracts have a standard limit of 5%, but the liquidity rider allows up to 10% (the contract might have benefits in other areas).
Keep in mind that liquidity riders can have annual charges of up to 0.95%, though. Be sure that you will genuinely need the greater amount of liquidity offered by the rider before committing to purchase one. Otherwise it will slightly reduce the interest that you earn in your contract each year.
The Bottom Line
Liquidity is important in retirement, but annuities can play valuable roles in a financial strategy. With a financial professional's help, shop around and see what benefits a fixed annuity or index annuity can provide for your retirement peace of mind.
Consult your financial professional about whether your annuity options have free withdrawal provisions. They can help you find contracts with this feature as well as others that help make your retirement more secure and financially confident.
What if you are looking for a financial professional to steer your retirement in the right direction? Help is a click away at Jennifer Lang Financial Services.