Understanding the IRS Penalty
The most known annuity penalty that can occur from (whether it be a fixed annuity, a fixed indexed annuity or a variable annuity) the IRS is the 10% penalty for withdrawals prior to age 59.5. If you withdrawal money prior to attaining the age 59.5 the IRS will impose a 10% penalty on top of any taxes that are owed on the distributions. This is similar to the penalty imposed for early withdrawals on retirement accounts. The reason for this, is simple, the IRS views annuities as long term retirement vehicles and as such grant them with tax deferral. Since the IRS grants special tax provisions for annuity policies they also impose penalties if they are not used as intended.
This 10% penalty can be avoided on immediate annuities however where the annuity provides income from either 1 month after payment to 1 year after payment for a specified period of time. Unless you are over age 59.5 or plan to not withdrawal your money before age 59.5 we recommend investing in another vehicle. There are other ways to avoid paying the 10% penalty if you are under age 59.5 (listed below):
Death of the annuitant
For most fixed annuities if the annuitant dies the money is left to a designated beneficiary. The beneficiary of that fixed annuity does not need to be 59.5 in order to receive the proceeds. Fixed annuities can be a very effective estate planning tool (described in more detail elsewhere).
Annuitization
Annuitization is what happens when the owner of an annuity policy decided to turn the fixed annuity into an immediate annuity. Essentially he is shifting from an accumulation phase (earning interest) to a distribution phase (receiving income). An immediate annuity is not considered an asset instead it is considered an income stream and as such avoids the 10% IRS penalty.