She Wanted Out of Her $250,000 Annuity at 71. The Surrender Charge Was 7%, and the IRS Taxed Every Dollar of Gain Before She Saw a Dollar of Principal
Cashing out a deferred annuity at 71 triggers two separate costs that stack against the retiree before she sees a single dollar, and the IRS determines which one hits first in a way most people never expect.
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A 71-year-old retiree wants to withdraw $250,000 from a deferred annuity before its surrender period ends. Getting out costs her twice: the insurance company takes a surrender charge, and the federal government taxes the gains, which the IRS counts as coming out before any of her original investment.
How a 7% Surrender Charge Works on a $250,000 Contract
Most deferred annuities require the money to stay in the contract for a set period, “usually five years, seven years, even 10 years,” according to Suze Orman. Leaving during that period means “you will pay a 7 to 10% surrender charge, usually decreasing 1% a year, every single year.”
A 7% charge on the full $250,000 contract value is $17,500, leaving $232,500. Some contracts figure the charge on premiums paid instead of on the current value, and many allow a limited penalty-free withdrawal each year. If her schedule falls one point a year, waiting 12 months would bring the charge down to 6%, or $15,000.
Why the IRS Taxes Gains Before It Returns Principal
A nonqualified annuity is bought with money that has already been taxed. For these contracts, the IRS applies LIFO accounting to treat earnings as withdrawn first. Every dollar taken out counts as taxable gain, taxed as ordinary income, until all the gain is gone. Only then does her tax-free principal start coming out. If we assume she paid $175,000 in premiums, this leaves $75,000 of gain, so a partial withdrawal of $50,000 would be fully taxable because it is less than the gain. At a 22% federal marginal rate, the tax would be $11,000.
A full surrender of the annuity works differently, as the surrender charge reduces what she gets, so her taxable gain becomes $57,500. At 22%, that produces about $12,650 in federal tax and leaves roughly $219,850 after the charge and the tax. Because she is older than 59½, the 10% additional tax on early distributions does not apply.
The extra income can also affect other parts of her taxes. Taxable interest and gains can affect the portion of Social Security benefits that becomes taxable. This matters more as benefits rise: the 2027 cost-of-living adjustment is tracking toward 3.3%. The LIFO treatment on nonqualified annuities is one of several quiet IRS rules that can drain a retirement account, and we detailed the rest in a free guide here.
What the Exit Money Could Earn Elsewhere
Many people weigh a surrender against what the money could earn elsewhere. As of September 25, 2026, the 1-year Treasury yielded 4.5%. I Bonds issued now earn a combined rate of 4.26% through October 31, 2026, and that includes a fixed portion of 0.9%. The national average 12-month CD paid 1.73% APY as of September 1. At the Treasury rate, $232,500 would earn about $10,462 a year. At the average CD rate, it would earn about $4,022. The comparison holds up next to the rate her annuity currently credits.
Short-term interest rates remain high. The upper bound of the Federal Reserve’s target range is 4%, up 0.25% from a month ago. The contract sets the surrender charge, which is unrelated to that rate.
Ways Out Other Than a Full Surrender
A Section 1035 exchange moves the contract into another insurance contract without recognizing the built-up gain as taxable income. That avoids the immediate tax bill, but the move generally restarts the surrender charge schedule. For a 71-year-old, that means locking the money up again for more years of retirement.
Other options include using the yearly penalty-free withdrawal allowance, waiting for the charge to step down, or annuitizing the contract. Annuitizing turns the balance into a stream of payments. Under IRS rules, each payment includes part of the original principal as a tax-free return, so it doesn’t all come out as gain at once.
What Decides the Final Number
What she keeps depends on three figures in her contract: the current surrender percentage, the premiums she paid, and how much of today’s value is gain. The surrender charge and federal tax together reduce $250,000 to about $219,850. That result would change with a different cost basis, another year on the schedule, or a lower tax bracket.
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David Beren has been a Flywheel Publishing contributor since 2022. Writing for 24/7 Wall St. since 2023, David loves to write about topics of all shapes and sizes. As a technology expert, David focuses heavily on consumer electronics brands, automobiles, and general technology. He has previously written for LifeWire, formerly About.com. As a part-time freelance writer, David’s “day job” has been working on and leading social media for multiple Fortune 100 brands. David loves the flexibility of this field and its ability to reach customers exactly where they like to spend their time. Additionally, David previously published his own blog, TmoNews.com, which reached 3 million readers in its first year. In addition to freelance and social media work, David loves to spend time with his family and children and relive the glory days of video game consoles by playing any retro game console he can get his hands on.
