Navigating annuity withdrawals is a critical skill for any retiree looking to maximize their income while minimizing tax liabilities. Unlike a traditional savings account, an annuity is a legal contract with specific rules governing how, when, and how much money you can take out.

In 2026, new regulations under the SECURE Act 2.0 have introduced more flexibility for certain types of withdrawals, but the core mechanics of taxes and penalties remain as complex as ever.

Types of Annuity Withdrawals

There are several ways to access the funds in your annuity, each with its own set of financial consequences.

  • Partial Withdrawals: Many contracts allow you to take out a portion of your account value for free, if such "free withdrawal" feature is elected as part of the contract. However, if the amount exceeds the "free withdrawal" limit, you may trigger surrender charges.

  • Systematic Withdrawals: This option allows you to schedule regular monthly or quarterly payments without formally "annuitizing" the contract. You retain control over the principal, but the payments are not guaranteed for life.

  • Full Surrender: This is the complete liquidation of the contract. You receive the total account value minus any applicable fees and taxes.

  • Annuitization: This converts your lump sum into a guaranteed stream of income for a set period or for life. Once you annuitize, you typically cannot go back to a lump sum.

Taxation of Annuity Withdrawals

The way your withdrawal is taxed depends primarily on whether your annuity is Qualified or Non-Qualified.

Qualified Annuities (IRAs, 401ks)

These are funded with pre-tax dollars. Because you have never paid taxes on this money, every dollar you withdraw is taxed as ordinary income. In 2026, these are subject to Required Minimum Distributions (RMDs) once you reach age 73.

Non-Qualified Annuities

These are funded with after-tax money (like savings from a bank account).Only the earnings portion of your withdrawal is taxable.The IRS uses the LIFO (Last-In, First-Out) method for partial withdrawals, meaning they assume the first dollars you take out are the taxable earnings.

Feature Qualified Annuity Non-Qualified Annuity
Funding Source Pre-tax dollars After-tax dollars
Tax on Principal Fully Taxable Tax-Free (Already Taxed)
Tax on Earnings Fully Taxable Fully Taxable
Withdrawal Rule Pro-rata (Total balance) LIFO (Earnings first)

The Cost of Early Access: Penalties and Fees

Taking money out of an annuity too early can be expensive due to two distinct types of penalties.

1. The 10% IRS Early Withdrawal Penalty

If you take a withdrawal before age 59½, the IRS generally imposes a 10% additional tax penalty on the taxable portion of the withdrawal. This is on top of your standard income tax rate.

2. Insurance Company Surrender Charges

Most annuities have a "surrender period" lasting 5 to 10 years. If you withdraw more than the allowed amount during this time, the insurance company will charge a fee, often starting around 7% and declining over time.

The 10% Free Withdrawal Provision

To provide some liquidity, many, but not all, annuity contracts include a free withdrawal provision. This typically allows you to withdraw up to 10% of your account value (or sometimes just the interest earned) each year without paying a surrender charge. This is a vital tool for managing unexpected expenses or supplementing retirement income without breaking the contract.

New 2026 Withdrawal Exceptions (SECURE 2.0)

As of 2026, the IRS has expanded the list of "triggering events" that allow for penalty-free withdrawals even if you are under 59½. Key exceptions to the 10% penalty now include:

  • Emergency Personal Expenses: One withdrawal per year up to $1,000 for family emergencies.

  • Domestic Abuse Victims: Withdrawals up to $10,000 or 50% of the account value within one year of the abuse.

  • Terminal Illness: Distributions for individuals certified by a physician as having a terminal condition.

  • Qualified Birth or Adoption: Up to $5,000 per child.

    Disclosure: The above is not professional advice. Speak to a financial advisor or accountant to see which rules apply to your case.

Strategic Withdrawal: The 1035 Exchange

If you are unhappy with your current annuity’s performance or fees but don't want to pay taxes on a withdrawal, you can use a Section 1035 Exchange. This allows you to move your funds directly from one annuity to another without triggering a taxable event. However, be cautious: a 1035 exchange often restarts the surrender period on the new contract.

Calculating the "break-even" point is essential. If a new annuity offers a significantly higher interest rate than your current one, it may be worth paying a small remaining surrender charge to move the money to a more productive vehicle.

Some fixed index annuities (FIAs) will offer premium bonuses that can help offset the surrender charge of the older annuity being exchanged.