The basics of annuity loans
Like your home or a life insurance policy, your annuity contract is an asset, the value of which you may be able to borrow against.
Some deferred annuities allow you to borrow a sizable amount from the contract’s account value, which you would repay back into the contract with interest.
Why you would need to borrow against your annuity
Deferred annuities typically have a surrender period, meaning the owner is required to leave most or all of the money in the annuity for a set period of time before they can take withdrawals. This will be determined before you purchase the annuity. The length can range from 3 to 15 years. At the end of the surrender period, you can either begin taking income, or you can renew the annuity for another period, though it will likely be at a different interest rate.
If the owner of an annuity insists on pulling money out before the end of the surrender period, the insurance company will assess a penalty. This is known as a surrender charge.
In addition to limitations from the insurance provider, the IRS also restricts access to annuity funds, depending on a person’s age. Because annuity account values grow on a tax-deferred basis, the money can’t be withdrawn until at least age 59 1/2. Withdrawals made before that are subject to a tax penalty.
The insurance company’s surrender charge is typically a percentage of the amount withdrawn. The percentage will decline over time. For example, your annuity may have an 8 percent surrender charge if you withdraw funds in the first year, a 7 percent charge in year 2 and a 6 percent charge in year 3.
Many annuities, however, offer a free withdrawal percentage. This provision allows you to take out a percentage of the annuity’s value without a penalty. A typical free withdrawal amount is 10 percent of the account value.
However, if you need more money than what the free withdrawal provides and you don’t want to surrender the contract, you may have the option of taking out an annuity loan.
Loan provisions will vary by company. Some will limit the amount you can borrow to half of the account value or to a dollar amount, such as $50,000. The length of time a borrower has to repay the annuity loan will depend on the company, but five years is the typical maximum timeframe.
Because loans are funds the borrower intends to repay — with interest — the IRS does not consider them income. Therefore, the borrower does not pay taxes on loaned funds from an annuity contract. However, if the fund are not repaid, they become a distribution from the contract and are therefore taxed as income. The borrower may also incur an early distribution tax penalty if the funds were taken out before he or she reached age 59 1/2, and the insurance company can also institute a surrender charge if the loaned funds are not repaid.
An advantage of borrowing from an annuity instead of a traditional source is that you do not have to worry about having a qualifying credit score since you’re essentially borrowing your own money.
One of the disadvantages of borrowing from your annuity is that the money you remove will not earn interest, which limits the assets you have available for retirement.
An alternative to borrowing directly from an annuity is to use the account value as collateral for a loan issued by a bank or other financial institution. This arrangement can get complicated, so you will want to discuss the option with the insurance company that issued your annuity, your lender, and a tax advisor.