Have you ever loaned yourself money? That’s the basic concept behind an annuity loan. If you’ve already signed an annuity contract and at least partially funded your account, you may have the opportunity to borrow against an annuity to cover urgent expenses. Whether you’re trying to figure out how to tackle debt or want to help your niece with college tuition, an annuity loan could help you close the financial gap—but only if the risk and interest rates are worth the reward.
What Is an Annuity Loan and How Does it Work?
Both fixed and variable annuities are typically used as long-term savings products. You sign a contract, fund your annuity, and get a steady retirement income stream after annuitization. But if you have a sudden need, you may be able to access some of your account principal or interest. This is called an annuity loan.
Here are a few key points you should understand before pursuing an annuity loan:
- Annuity loans can provide fast access to cash in an emergency without surrendering your annuity and sacrificing your retirement income potential.
- You must repay the total loan amount plus any interest by the agreed-upon deadline (usually within five years).
- Not all insurance companies offer annuity loans. Even if your contract technically allows for an annuity loan, you must have enough cash in the account to meet eligibility requirements.
- Annuity loans are only available during the accumulation phase of a deferred annuity, prior to annuitization. Once the contract is annuitized, the loan option is no longer available.
- In general, annuity loans are only available to the owner of the contract. If the annuitant and owner are separate entities, the annuitant does not have the authority to make withdrawals or change the contract in any way. This typically includes policy loans. You should verify with the insurer as to which party can apply for an annuity loan.
Types of Annuities You Can Borrow Against
You can only borrow from your annuity if it’s a deferred annuity that’s still in the accumulation phase. This includes fixed, indexed, and variable annuities, though borrowing against an annuity can compromise future earnings. Your loan amount is deducted from the annuity’s account value, which means you’ll earn interest at a slower pace until the loan is repaid.
You can’t borrow against an immediate annuity, because that type of annuity has no accumulation phase and starts distributing income within 12 months.
You may be able to sell the income from an immediate annuity in exchange for a lump-sum payment (also known as commutation), but you’ll receive less than you would if you stuck to the contracted payment schedule.
Qualified Annuities vs. Nonqualified Annuities
Qualified annuities are funded with pre-tax income from a qualified retirement account, such as a 401(k) or IRA. The money you take from that annuity as a payout or distribution later on is then taxed as income for that tax year. In contrast, nonqualified annuities are funded with post-tax dollars. You’ve already paid taxes to the IRS before using the cash for your annuity premium, so only the interest credited is taxed upon payout.
That distinction is important because how you funded your annuity helps determine what taxes will apply to an annuity loan. If you borrow against a nonqualified annuity, you may be able to access the money without incurring penalties or doling out additional taxes.
When borrowing against retirement accounts, you may be able to avoid penalties if you:
- Borrow a maximum of $50,000 or 50% of the vested account, whichever is less.
- Plan to use the loan to help buy your first home.
- Pay back the loan within five years.
Even if you meet those terms, taking a loan against a qualified annuity can be problematic. The big issue is taxation. Qualified annuities are funded using pre-tax dollars, but you’ll likely repay your annuity loan using current income that’s subject to income taxes for that calendar year. Since you’ll be taxed on that annuity account’s payouts once distributions begin, you could conceivably pay taxes twice on at least a portion of your retirement savings.
Using Your Annuity as Collateral for an External Loan
Because a deferred annuity has quantifiable value, some financial institutions will accept an annuity as collateral for a traditional bank loan. As with internal annuity loans, insurance companies usually limit annuitants to leveraging a maximum of 50% of their account value to secure an external loan.
Be wary of using a nonqualified annuity as collateral in this situation. Even though money isn’t technically coming out of your annuity account, the IRS may label your total loan amount as a “nonperiodic distribution.” That could trigger tax obligations, especially if you’re under the age of 59 ½.
While you may be able to directly borrow from qualified annuities, such as an IRA, 401(k), or 403(b), you cannot use them to guarantee an external loan.
Pros and Cons of Annuity Loans
An annuity loan can provide a much-needed financial safety net, but there are pros and cons to borrowing money from your retirement savings.
Pros of Annuity Loans
- Fast access to cash: You can obtain money relatively quickly if you’re in a pinch and can’t or don’t want to liquidate other assets.
- Better preservation of your account principal: A loan that’s paid back in full and on schedule may have less impact on your account principal and future distributions than an early withdrawal.
- Fewer penalties and fees: Taking out an annuity loan instead of initiating a withdrawal may save you money on surrender charges and early distribution penalties.
- Expanded eligibility: You may be approved for an annuity loan even if you have been rejected by other lenders.
Cons of Annuity Loans
In addition to the potential tax burden of paying back a loan from a qualified annuity account, you should consider these factors before borrowing against your annuity.
- Risk of default: If you fail to repay your loan on time, you may be subject to significant surrender charges and tax implications if you haven’t reached the age of 59 ½.
- Lowered growth potential: An annuity loan lowers the overall value of your account and you can only earn interest on the remaining value. This compromises your annuity’s growth potential until the loan is fully repaid (though perhaps not as much as an early withdrawal, which permanently lowers your account value).
- Paying for the privilege of a loan: You must pay back the loan principal plus interest, increasing the overall cost of your annuity.
What Happens if You Default on Your Annuity Loan?
If you fail to repay your annuity loan, your insurance company may reclassify the loan as an annuity distribution. This reclassification can have significant consequences:
- If you’re under the age of 59 ½, the insurance company may assess an early withdrawal penalty of up to 10% of the loan value.
- The loan becomes a withdrawal, and the unpaid balance of that loan will be treated as taxable income. If you default on a loan and you’re under the age of 59 ½, you may also be subject to an additional 10% tax penalty from the IRS.
- Because the loan is now an irrevocable withdrawal, you’ll sacrifice some of your earnings growth potential due to a lower overall annuity account balance.
When To Borrow Against Your Annuity: How Do You Decide?
Some annuity contracts include loan options. If you’re thinking about borrowing money from your annuity, ask yourself these questions:
How Immediate and/or Important is Your Financial Need?
Deferred annuities work best if they’re left alone to generate interest and pay out as planned. But if you need money quickly, perhaps for unexpected medical bills or to buy a house while the market is favorable, an annuity loan might make sense.
Is an Annuity Loan Your Only Option?
Depending on your loan terms, your interest rate, and where you are in your annuity’s accumulation phase, you may be better off pursuing alternatives to an annuity loan. Personal loans, home equity loans, and regular annuity withdrawals (assuming you’re over the age of 59 ½) may offer more favorable terms and lower risk.
You can also plan ahead and potentially lower reliance on annuity loans by adding annuity riders to your contract. Options like a long-term care (LTC) rider can give you access to funds earmarked for specific purposes—in this case that’s long-term care costs, such as paying for a nursing home—without borrowing against your account value.
How To Apply for an Annuity Loan
Interested in applying for an annuity loan? Here’s how you can get started:
- Contact the insurance company that holds your annuity contract and ask about their loan options.
- Dig into the details of potential loan offers. Pay particular interest to the proposed payback period, the interest rate offered, and any fees or penalties you may have to cover should you decide to proceed.
- Gather the required documentation, such as a copy of your government I.D., proof of address, and recent bank statements and/or pay stubs.
- Fill out and submit your application, then wait for a formal approval or denial.
- If your loan request is approved, you’ll be asked to sign a detailed contract. Review the loan’s terms for consistency and make sure you understand everything thoroughly before signing.
- Take your lump-sum loan payment.
- Make regular payments until you’ve paid off the full balance of your loan, plus interest.
Note: Before taking out an annuity loan, we recommend that you talk to a qualified financial advisor or accountant who is familiar with annuity loans and their implications.
More About Annuity Loans and Your Financial Flexibility
Borrowing money from your annuity may feel like a safe, low-risk option, but you must take a measured look at interest rates, potential penalties, and the risk of default before opting to move forward. While annuity loans can seem like a quick way out of a sticky situation, the potential downsides cannot be ignored. If you’re risking your future retirement income to mitigate current expenses, make sure the trade off makes sense.
For more information about annuities, connect with a trusted Annuity.com agent today.
