What's the Least Painful Way to Get Out of a Bad Annuity?

In this Answers, Answers segment from an episode of Motley Fool Answers, Alison Southwick and Robert Brokamp try to help a woman whose parents were likely led financially astray by the person who sold them a variable annuity for her. These assets have some merits, but their returns in general aren't all that great.

And, unfortunately, selling before you're 59 1/2 means an ugly IRS penalty. However, Sarah's money isn't entirely trapped.

A full transcript follows the video.

This video was recorded on Dec. 5, 2017.

Alison Southwick: It's time for Answers, Answers, and today's question comes from Sarah. Sarah writes, "I'm 37 years old and have saved almost $500,000 for retirement." Good for you!

Robert Brokamp: Very good for you!

Southwick: "My parents opened a variable annuity for me in 1990, thinking it was a way to save for college, but it didn't grow as fast as they'd hoped, and they didn't realize that there would be a penalty for pulling the money out before I'm 59 1/2. I'm debating between a few options. Move it into a different fund within the same annuity, roll it into a new annuity, or pull it out, take the penalty and income tax it in order to invest it into non-retirement funds. I'd appreciate your thoughts. I've tried to research variable annuities and I'm still kind of fuzzy on them."

Brokamp: Well, you're not alone. Variable annuities can be very complicated. In their essence, they're sort of like traditional 401(k)s in that once you put the money in, it grows tax-deferred. You don't pay the taxes until you take the money out, and you have limited investment choices. Usually just a few mutual funds in there.

The problem is it's an investment account but also has an insurance element to it, which makes them more expensive. The investments tend to be pretty mediocre. I'm going to guess that your parents were actually sold this annuity by an insurance agent who said, "Yeah, this is a great way to save for college," because they generate huge commissions for insurance sales. I'm sure it wasn't your parents' fault, but they are right to find out that eventually, yes, like a 401(k), if you take the money out early, you're going to pay a 10% penalty on top of taxes on the money.

Southwick: But if you can't even take the money out until you're 59 1/2, how can they even tell you it's good for college?

Brokamp: They shouldn't have. It's 1990, so you probably can't...

Southwick: The people just lied.

Brokamp: ...go back and find that agent. I bet, I'm guessing, that if it was sold by an agent, that they said things they shouldn't have said.

Southwick: Just flat-out lied.

Brokamp: Yes, exactly. So, here are your choices, and you'll recognize them. You could look at better investments within the annuity, but chances are if it hasn't grown very well, it's just a bad annuity. Many of them have extraordinarily high expenses. My recommendation would be to look at your other option, which is to transfer it to another annuity. It's something called a "1035 exchange." You don't owe any taxes as long as it goes from one annuity to another. Look for a low-cost provider from folks like Vanguard and Fidelity and people like that. They have low-cost annuities that are available.

I wouldn't recommend taking the money out because, as I said, you'll pay the penalties and the taxes. You are doing pretty well for saving for your retirement, so if push came to shove and you needed that money, it wouldn't be the worst thing in the world to cash it in. I know people who have done stuff like that to maybe start a business or something like that. Because you're doing well for your savings and retirement, I wouldn't say it's the worst thing in the world, but you don't want to pay those penalties, so better off to save it for retirement, transfer it to a lower cost annuity, and then if you ever need cash in the future, just pull back on the amount you contribute to your 401(k).