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Tax consequences of liquidating an annuity

If you've recently been sold an annuity that you now realize just doesn't make sense for you, you may be able to get out of it unscathed by exercising your "free look" provision.This is a kick-the-tires grace period in which you can terminate the policy and get your money back without paying a surrender charge.

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A California resident who moves to Nevada, Florida or other "no-tax" state (and becomes a non-California resident) only pays a 15 percent federal capital gains tax (rather than the 21.04% blended California and federal tax, and the 1% individual California surtax).If taking a partial withdrawal, it is taxed using the LIFO (last-in, first-out basis) method, meaning that the earnings are taxed first.All deferred annuity withdrawals are taxed at ordinary income tax rates since the contributions were never taxed.It is important to note that if under age 59 ½, an additional 10% early distribution penalty tax will be due on taxable annuity distributions unless the owner qualifies for an exemption from the IRS penalty tax.The vast majority of deferred annuities have surrender charges if taking a distribution during the surrender charge period of the policy, which usually lasts from as short as 4 years to as long as 20 years.While qualified (retirement) accounts benefit from tax deferral, nonqualified annuities also are tax-deferred vehicles.

In a taxable investment vehicle, the account holder is required to pay taxes on dividends and interest generated by the investment as well as capital gains tax on realized gains on an annual basis.

This 2006 Tax Act extends the 15 percent federal capital gains and dividend rate for two additional years until December 31, 2010.

These lower tax rates reduce the federal tax cost of selling a business.

For instance, if you invested $30,000 in a variable annuity in 2008 and just got back to even, you won't have to pay taxes or gains if your distribution is $30,000 or less. ) You may still have a surrender charge to consider, but if it is nominal, it may be worth cutting loose to avoid tying up your money for decades to come.

If you have a highly appreciated annuity and don't want to create a tax time bomb for you or your heirs, you may (likely) have the option to annuitize the product.

The benefits of annuities are often overshadowed by their negative qualities—especially their notoriously high expenses and illiquidity.