Tax Penalties on Cashing in Annuities

Tax form

In formal tax code, the IRS says that cashing in annuities falls under the category of "nonperiodic payments." It is generally never advantageous to cash in an annuity early, as annuities have special tax privileges under IRS code, and the IRS has put into effect several penalties for taking money out early. Be sure to contact a financial planner before you make any final decision, as he will be able to best advise you on whether or not to cash in your annuity and how to go about doing so.

Immediate Penalty

Withdrawals from your annuity (cashing in is essentially one giant withdrawal) before age 59 1/2 results in an instant tax of 10 percent paid to the government, according to IRS Publication 575. This money is still included as gross taxable income when you figure your income taxes for the year.

Taxable Income

You must include your entire cash withdrawal as taxable gross income when filing your taxes that year. You are likely paying taxes twice on the same money, because you paid taxes on your income before you put it in your annuity, but this is part of the penalty for cashing in an annuity early.

Avoiding Tax Penalties

There are two ways to get rid of your annuity without being forced to pay massive tax penalties: 1035 exchanges and secondary markets for annuities. A 1035 exchange allows you to move money from one annuity to another without having to "withdraw" the money, and therefore you face no tax penalties. The secondary markets are just what they sound like--an opportunity to sell your annuity for cash to someone else. According to a Business Week article, the price is determined by the total amount of the annuity, its length and current interest rates. Two types of annuities are ineligible to be resold, however: annuities in retirement accounts and immediate annuities that don't have guaranteed payouts.