Sorry, but there's no way to avoid paying taxes when you cash in an annuity

Q: Years ago, I bought a fixed deferred annuity, as I didn't have, and still don't have, any retirement plan at work. The banker said it was like a certificate of deposit except I didn't have to pay tax on the interest.

Over the years, I've been contacted to renew the term, and restrictions on my ability to take money out start over.

When the current term matures in six years, can I take the lump sum and invest it as I wish, or do I have to take lifetime payments to avoid paying taxes on the interest?

I put in $20,000 of after-tax dollars and the annuity is now worth $45,000.

A: Fixed annuities, as the name implies, pay a fixed rate of interest. Although often sold at banks, they are issued by insurance companies and are not bank products. The issuing company, not any government agency, makes annuity guarantees.

Still, fixed annuities from financially strong insurance companies are considered fairly safe investments. Like CDs, many pay a set rate of interest, declared in advance, for a set period of time. And just as with CDs, you'll lose some of your money if you want to cash them before the term ends.

With bank CDs, the early withdrawal penalty is usually a few months' interest. With fixed annuities, you typically pay stiffer "surrender charges" that amount to a percentage of principal. On a six-year fixed annuity, a typical surrender charge may be 6 percent the first year, declining one percentage point each year until there is no charge after six years.

Many fixed annuities give you a window of say 30 days at the end of each term to cash it in without surrender charges. Every time you renew, surrender charges usually start all over again.

Sorry, but there is no way to take money out of the annuity without paying taxes on the interest. It's not accurate to say you don't have to pay taxes - you only delay paying the taxes until you take your money out. On top of regular taxes, there's generally a 10 percent tax penalty if you take money out of an annuity before age 59 1/2. If you cash in the annuity as a lump sum, you will owe taxes on the difference between the account value at the time of withdrawal and the $20,000 you put in. If you take lifetime annuity payments, taxes will be spread out but not spared. Part of each lifetime payment will be considered a tax-free return of the original $20,000 principal but another and bigger part will be taxable interest.

Many annuities allow investors to withdraw either the annual interest or 10 percent of principal a year without surrender charges, but the 10 percent penalty still applies if under 59 1/2. This type of withdrawal from your annuity will be fully taxable until there is only $20,000 left in the account, or what you put in initially.

You did not say whether you have ever opened an individual retirement account, or IRA. As a rule, you should contribute the maximum to an IRA before buying fixed annuities. Both give you tax deferral, but fixed annuities generally place more restrictions on accessing your money.

Humberto Cruz is a columnist for the South Florida Sun-Sentinel.