People can choose to get annuity loans, which let them borrow money depending on the value of their annuity contract. Need some quick cash? You can use your pension as collateral for these loans.
It’s important to really think about the consequences of this. Getting a loan against an annuity can be a bit pricey due to high interest rates and fees. Plus, taking out money from an annuity too soon could lead to some not-so-fun tax penalties.
In this article, we will discuss all you need to know about annuity loans. We will tell you what they are: when you can take one, the process involved in taking one, as well as the advantages and disadvantages of taking this kind of loan.
You will surely learn a lot by the time you are done reading.
What are annuity loans?
Annuity loans, or annuitetslån, as they are called in Norwegian, happen when an annuity holder borrows money against the cash value of their annuity contract. It allows a person to access the funds kept for their retirement without having to cash out on this source of income.
To better understand the definition above, we need to explain the terms annuity, annuity holder, and annuity contract.
An annuity is a contract between a person and an insurance company where the person makes one or more lump sum payments, which the insurance company will then reimburse the person for as disbursements at regular intervals that may begin right away or at a later date.
The payment from the insurance company that is made later is known as a deferred annuity.
From the above, the person who makes the payment to the insurance company is known as the annuity holder.
An annuity contract can be between a minimum of two parties: the holder and the issuer (the insurance company). Or it could be between a maximum of four parties: the holder, the issuer, the beneficiary, and the annuitant.
Seeing as we have explained who the holder and issuer are, that leaves us with the beneficiary and the annuitant.
The annuitant is the person whose life expectancy is the determinant of the amount as well as when the payments will begin and end. Usually, the holder and the annuitant are the same person. The beneficiary, on the other hand, is the person who receives the benefit in case the annuitant dies.
The contract ensures that the insurance company makes the payment when the agreed-upon time is reached. It is risk-free for the holder, annuitants, and beneficiary.
Forms of Annuity
Four forms exist, which we discuss briefly below:
1. Immediate
This type is also called a retirement annuity. Once this type is chosen, the insurance company will begin to make payments to the individual immediately after the contract is purchased via a lump-sum payment. Hence, the owner does not have to wait for retirement or a certain age before receiving payment.
2. Fixed
This type, as the name implies, is an amount of money that is fixed and paid by the insurance company despite the investments’ performance.
3. Deferred
This is the reverse of an immediate annuity. In this case, either a lump-sum or regular payment is made to the insurance company. The money is now paid back to you later in the future, usually at retirement age or any age agreed upon.
4. Variable
Unlike a fixed annuity, this type allows the issuer to make payments based on the performance of the investment. Hence, an owner could lose the principal if the investment performance is lower than when the contract was purchased.
This type alone has this disadvantage. Nevertheless, you can take certain precautions during the contract signing that offer you protection from such losses.
You will have to enlist the help of a financial professional to aid you when choosing this form of contract. Click here to learn more about the types of annuities in detail.
When can a loan be taken out?
When a holder chooses the deferred type of contract, it means he wants to receive payment from the insurance company later. As a result, the holder makes regular payments to the insurance company to purchase the entire contract.
When the holder reaches retirement age (which is presently 59 ½ years), the insurance company will then begin to pay the holder the money agreed in the contract every month.
However, the holder can choose to borrow from the contract’s total cash value before they reach their retirement age. When this is done, such a loan has to be paid back over some time (usually five years) and with interest.
The Process of Taking a Loan
The loan process begins with an official request submission from the holder to the contract issuer, which is usually an insurance company. The request could be approved or declined, depending on several reasons.
Upon approval of the loan, the loan is then processed, and a bulk sum is paid to the holder, who is then expected to pay back the loan at regular intervals to clear up the load.
A good number of issuers will allow their holders to borrow up to a maximum of 50% of their total cash value. Nevertheless, the terms and conditions differ from one insurance company to another. Hence, it is expected that you make proper findings and research before taking out an annuity loan.
Advantages of Taking a Loan
The first advantage of taking this sort of pension loan is that it offers you protection from the payment of “surrender charges.”. A surrender charge is the amount of money paid to the insurance company if a contract is cancelled before the agreed-upon time.
The effect of surrender charges on the cash value is so great that it can cancel any gain that the holder would have acquired from the contract in the first place. Hence, taking out this type of loan is a great way to escape this issue and still keep the contract.
Another advantage of taking an annuity loan is that it protects you from the penalty known as “early distribution” and taxes. Usually, if an owner sells their payment right before retirement age, a 10% penalty charge known as early distribution is made on the withdrawn amount.
Furthermore, when the annuity is sold, it becomes taxable, which can further reduce the overall value.
Hence, instead of selling, most owners just borrow to avoid the charges mentioned above that can reduce the cash value.
Disadvantages of Taking an Annuity Loan
The first disadvantage lies in the inability of the owner to repay the loan within the stipulated time frame. When this occurs, it is regarded as a distribution. This always carries a penalty charge of 10%, which, as we mentioned above, is known as “early distribution.”.
Another disadvantage is that when you borrow from your pension, the capacity of your investment to grow is affected, and potential earnings that you would have received are foregone.
How do I liquidate an annuity?
If you choose to liquidate rather than take a loan, as discussed above, there are two ways of cashing out on one’s pension contract before retirement age. We will discuss both ways below.
By Withdrawals
An owner can request withdrawals from their issuer before their retirement age. The problem is that doing this might cause one to pay the IRS a 10% penalty and the insurance company a surrender charge.
Hence, this is not advisable for any owner, as the loss could be really great compared to the total cash value. But if you want to go ahead, we recommend that you speak with a professional in the financial sector; a tax adviser or public accountant should be able to give you advice on what you stand to lose.
By Selling
Yes, it can be sold, and this is the second way you can cash out this source of income. You are afforded the choice of either selling all the payment rights or keeping a part of them. That means you can either sell it completely or sell it in part.
While doing this, you need to know that the value will always be less than what it is currently and also less than what its future worth will be. Hence, you will still gain more if you are patient enough with your future payments.
Apart from this, the company aiding you in transacting the sale will also be paid a fee once it is sold. This fee is an additional cost that will cause the cash value to drop significantly.
Conclusion
An annuity is a great investment that keeps your money safe, secures your future, and can even benefit your loved ones. The fact that one can take loans out of it is an added advantage. And we hope the article above has equipped you with the relevant information you need.
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