Uncle Sam wants us to save for retirement, and that’s why annuities have special features and tax benefits. Where there are tax benefits, there are usually strings attached. Annuities are no exception.
Borrowing from your deferred annuity, or using it for collateral can have some very unhappy tax consequences. Here's how annuity loans work.
Non-Qualified Fixed Annuity and Variable Annuity Loans
Non-qualified annuities are not part of a pension plan or an IRA. They are bought individually with after-tax dollars. Non-qualified annuities usually do not have loan provisions. They can be used as collateral for a loan from a bank or any other third party.
A loan that has a fixed annuity or variable annuity as collateral is considered to be a nonperiodic distribution. Here is the problem. Nonperiodic distributions from annuities are taxable up to the amount of gains that have been accumulated. The taxes are paid at ordinary income rates. If you are under the age of 59 1/2, you will also pay a 10% penalty tax.
Annuity Loans and Retirement Plans
Qualified annuities are bought with pretax dollars. They are part of a pension plan or an IRA. Loans are not permitted in an IRA for any reason. Annuities that are part of an IRA cannot be used as collateral.
Loans are available from deferred annuities that are part of a pension if the plan allows it. Loans can be taken without penalty if:
- The money is used to purchase a home
- The loan is paid back systematically within 5 years
Annuities that are part of a pension plan will often have loan provisions.
Should You Take Loans from Your Annuity?
Annuities are retirement products. By design they are long-term investments. Using your non-qualified annuity as collateral for a loan is potentially very expensive. In addition to the interest charged, the loan can result in unexpected taxes and penalties.
Borrowing from your qualified annuity can also be very expensive. The interest rate charged by the insurance company may be higher than other alternatives.
|Account Value||Cash value of annuity before surrender charges.|
|Accumulation Phase||Period when purchase payments are made and money is accumulated in subaccounts.|
|Accumulation Unit||Measure of variable annuity account value.|
|Asset Allocation||Distribution of purchase payments across asset classes, stocks, bonds, etc.|
|Asset-Based Fees||Fees and expenses calculated as a percentage of the account value.|
|Capital Gains Rate||Federal tax rate applies to long-term capital gains.|
|Cost Basis||Sum of annuity purchase payments.|
|Distribution Phase||Period when income is distributed on a regular basis. Also known as payout phase.|
|Gain||Account value in excess of purchase payments.|
|Investment Manager Fees||Professional management fees for subaccount funds.|
|Living Benefits||Optional variable annuity features that protect against investment risk.|
|Mortality And Expense Fee||Charge for providing guaranteed death benefit and lifetime income rates.|
|Ordinary Income Rates||Federal tax rates applied to wages, salaries, tips, commissions, and other types of income. The ordinary income rate does not apply to long term capital gains.|
|Penalty Tax||10% federal tax on annuity, IRA, and qualified plan withdrawals before age 59 1/2.|
|Rebalancing||Realigning asset class allocations within a portfolio.|
|Subaccount funds||Investment funds offered in a variable annuity.|
|Surrender Charge||Charge for withdrawals during the surrender period usually 5 -7 years.|
|Surrender Value||Account value minus surrender charges.|
Don’t Go It Alone
Annuity loans are complicated transactions. Be sure to consult your professional advisor before taking a loan from your annuity.
TrustedChoice.com Article | Reviewed by Jeffrey Green
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Advisor’s guide to annuities John Olsen
IRS Pub 575
IRS Pub 410