Annuity Surrender Periods: What They Are and How to Avoid Penalties

One of the most important things to understand before buying a deferred annuity is the surrender period. This is the window of time — typically 6 to 10 years — during which the insurance company will charge you a penalty if you withdraw more than a specified amount from your contract. Surrender charges exist because the insurance company invests your premium in long-term assets to back the guarantees in your contract, and early withdrawals disrupt that investment strategy.

Surrender periods are not inherently bad. They are the mechanism that allows insurance companies to offer competitive interest rates and income guarantees. However, if you do not understand them before you buy, they can become an expensive surprise when you need access to your money. This guide explains how surrender periods work, what a typical schedule looks like, how to use free withdrawal provisions, and strategies to minimize or avoid penalties entirely.

What Is a Surrender Period?

A surrender period is a set number of years after you purchase a deferred annuity during which the insurance company imposes a surrender charge on withdrawals that exceed the contract's free withdrawal allowance. The surrender charge is a percentage of the amount withdrawn, and it declines over time on a predetermined schedule until it reaches zero. Once the surrender period ends, you can withdraw your entire balance at any time without a charge from the insurance company.

A typical surrender schedule for a seven-year annuity might look like this: 7 percent in year one, 6 percent in year two, 5 percent in year three, 4 percent in year four, 3 percent in year five, 2 percent in year six, and 1 percent in year seven. After year seven, the surrender charge drops to zero. Some products have shorter periods (3 to 5 years), and others extend up to 10 years or longer, particularly for variable annuities with generous bonus features.

The surrender charge is calculated on the amount withdrawn beyond the free withdrawal allowance, not on the entire account balance. For example, if your annuity has a $200,000 balance with a 10 percent free withdrawal provision and you withdraw $40,000, the first $20,000 (10 percent of the balance) is surrender-charge-free. The remaining $20,000 is subject to the applicable surrender charge. If the charge is 5 percent, you would pay $1,000 in surrender fees on the excess withdrawal.

Free Withdrawal Provisions

Nearly every deferred annuity includes a free withdrawal provision that gives you access to a portion of your money each year without triggering surrender charges. The most common free withdrawal allowance is 10 percent of the account value per year, though some contracts calculate it differently.

There are several common variations in how free withdrawal provisions work:

• 10 percent of account value: The most common provision. Each year, you can withdraw up to 10 percent of your current account value without a surrender charge. As your balance grows, the dollar amount you can withdraw also grows.
• 10 percent of premium: Some contracts base the free withdrawal on the original premium amount rather than the current value. If you deposited $100,000, your free withdrawal is $10,000 per year regardless of growth.
• Interest only: A few contracts allow you to withdraw only the interest earned without touching the principal. This is less common but can be useful for people who want income without reducing their balance.
• Cumulative vs. non-cumulative: In most contracts, the free withdrawal allowance does not roll over. If you do not use it in a given year, you lose it. A few contracts allow cumulative free withdrawals, meaning unused allowances carry forward. Always check your contract to understand which type you have.

The free withdrawal provision is one of the most practical features of a deferred annuity. It provides access to a meaningful portion of your money each year while you wait for the surrender period to expire. If you plan your withdrawals carefully, you may never need to pay a surrender charge at all.

Market Value Adjustments

Some annuity contracts include a market value adjustment (MVA) in addition to the surrender charge. An MVA adjusts the amount you receive when you surrender or withdraw beyond the free amount based on changes in interest rates since you purchased the contract.

If interest rates have risen since you bought the annuity, the MVA works against you and reduces your surrender value. This is because the insurance company invested your premium at the lower rates prevailing when you purchased, and they would need to sell those investments at a loss to return your money. If interest rates have fallen, the MVA works in your favor and may increase your surrender value. The MVA can either add to or offset the surrender charge, depending on the direction of rate changes.

Annuities with MVAs often offer higher initial interest rates than those without them, because the MVA shifts some of the interest rate risk to the policyholder. If you are considering an annuity with an MVA, make sure you understand how the adjustment is calculated and how it could affect your surrender value in a rising rate environment. Not all annuities have MVAs, so if liquidity is a priority for you, consider a product without this feature.

Strategies to Avoid Surrender Charges

With careful planning, you can minimize or completely avoid paying surrender charges. Here are several strategies that work:

Use the free withdrawal provision: Take advantage of the 10 percent annual free withdrawal each year. If you only need a small portion of your annuity balance for living expenses, this provision may be sufficient to meet your needs without triggering any charges.

Choose a shorter surrender period: If liquidity is important to you, consider an annuity with a 3 to 5 year surrender period instead of 7 to 10 years. Shorter surrender products may offer slightly lower interest rates, but the increased access to your money may be worth the tradeoff.

Ladder your annuities: Instead of putting all your money into one annuity with a long surrender period, split your funds across multiple annuities purchased at different times or with different surrender durations. For example, you might buy three annuities with 3-year, 5-year, and 7-year surrender periods. As each one matures, you have full access to that portion of your savings without charges.

Use the free-look period: After purchasing an annuity, you have a free-look period (typically 10 to 30 days, depending on your state) during which you can cancel the contract and receive a full refund. If you have second thoughts or discover something about the contract you did not expect, this is your no-cost exit window.

Wait out the surrender period: The simplest strategy is patience. If you do not need the money immediately, let the surrender period run its course. Once it expires, you have full, penalty-free access to your entire balance. This is why financial advisors stress the importance of only putting money into a deferred annuity that you truly will not need for the duration of the surrender period.

Penalty-Free Exceptions

Most annuity contracts include specific exceptions that waive surrender charges under certain circumstances. These vary by contract and by state, but the most common penalty-free exceptions include:

• Death: When the annuity owner dies, the death benefit is typically paid to the named beneficiary without surrender charges. The full account value (or a guaranteed minimum death benefit, if the contract includes one) passes to the beneficiary.
• Disability: Some contracts waive surrender charges if the owner becomes totally and permanently disabled. The contract will specify the definition of disability and any documentation required.
• Nursing home or long-term care confinement: Many contracts include a nursing home waiver that eliminates surrender charges if the owner is confined to a nursing home or long-term care facility for a specified period, typically 30 to 90 consecutive days. Some states require this waiver by law. This provision ensures you can access your money to pay for care when you need it most.
• Terminal illness: Some contracts waive surrender charges if the owner is diagnosed with a terminal illness. The contract will define what qualifies as a terminal diagnosis, often requiring a physician's certification that life expectancy is 12 months or less.
• Annuitization: Most contracts allow you to annuitize (convert to a stream of lifetime payments) at any time without surrender charges. This gives you full access to your money in the form of guaranteed income, though you give up access to the lump sum.

It is important to note that these waivers apply only to the insurance company's surrender charges. They do not waive the IRS 10 percent early withdrawal penalty for distributions taken before age 59 and a half, except in the case of death or disability. Always check your specific contract for the exact waiver terms and qualifying conditions.

How Surrender Periods Affect 1035 Exchanges

If you are considering a 1035 exchange — a tax-free transfer from one annuity to another — the surrender period plays a critical role in your decision. A 1035 exchange eliminates the tax consequences of switching contracts, but it does not waive the surrender charges on the old contract. If you are still within the surrender period, the outgoing insurance company will deduct the applicable charge before transferring the remaining balance to the new company.

Additionally, the new annuity contract will typically have its own surrender period, which starts from day one. This means your surrender period clock resets. If your old contract had three years remaining on its surrender schedule and the new contract has a seven-year surrender period, you have just committed to seven more years of limited access. For this reason, many advisors recommend waiting until the surrender period on your current annuity has expired or is close to expiring before initiating a 1035 exchange.

Questions to Ask Before You Buy

Before purchasing any deferred annuity, make sure you understand the surrender terms by asking these questions:

• How long is the surrender period, and what is the charge schedule for each year?
• What is the free withdrawal allowance, and how is it calculated (account value or premium)?
• Does the contract include a market value adjustment, and how is it calculated?
• What penalty-free exceptions are included (death, disability, nursing home, terminal illness)?
• How long is the free-look period, and what are the cancellation terms?
• Am I confident I will not need this money for the full duration of the surrender period?

The surrender period is not a reason to avoid annuities altogether. It is a feature you need to understand and plan around. When you buy an annuity with money you genuinely do not need for the duration of the surrender period, the charges are irrelevant because you never trigger them. The key is matching the right product to the right money. Keep your emergency fund and short-term savings in liquid accounts, and use deferred annuities for money that is earmarked for future retirement income. Consult a financial advisor to determine which product structure fits your timeline and liquidity needs.