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Deferred annuity owners can get temporary, tax-free access to their account funds through an annuity loan. Generally, annuity loans can equal up to one half of the account balance. As long as loan payments are made on time, the loan amount is not taxed.
Loan payments and interest are paid back into the annuity account. If the owner stops making loan payments, or defaults, the loan is treated as a distribution. In the United States, annuity distributions are subject to income tax. A penalty tax is also charged if the borrower is under age 59 1/2.
Generally, insurance companies provide annuities. These insurance companies set the interest rates and terms and conditions for annuity loans. Some companies charge loan service fees in addition to interest.
Annuity loans are preferred over withdrawals to access annuity funds. Loans can save the owner money on taxes. Withdrawals are immediately subject to income tax and penalty tax, if applicable.
Borrowers usually have up to five years to repay an annuity loan. Some insurance companies extend the repayment period for loans used to purchase a primary residence. The extended repayment term is usually no more than 20 years.
These loans also have some downsides. If one is not paid back on time, it is treated as a distribution. The borrower is required to immediately pay back the loan, outstanding interest, loan fees, plus any taxes due. If the owner cannot repay the loan, interest will continue to accrue on the outstanding loan balance.
Annuities are designed to build tax-deferred earnings. These earnings are then paid out in installments, to provide income during retirement. Loans will slow down the annuity's earning power until funds are paid. Any outstanding loan balance does not earn interest.
When a loan against an annuity is never repaid, the owner will defeat the purpose of the annuity. Any funds not returned to the annuity will no longer contribute to the tax-deferred growth of the account. This decreases the funds needed to provide income during retirement.
Outstanding annuity loans also prevent the owner from transferring, or rolling over, the annuity to another insurance company without penalty. Generally, the borrower must keep the annuity with the current insurance company until the loan is repaid. Some insurance companies will allow the transfer. In this case, any outstanding loan balance is treated as a distribution and taxed accordingly.
If the annuity is part of the borrower’s company retirement plan, annuity loans have additional risk. Usually, if the borrower leaves the employer or is terminated, the outstanding loan balance must be repaid immediately. If the employee is unable to repay the loan, the outstanding loan balance becomes a distribution. Income tax, and possibly penalty tax, will apply.
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