What is an Annuity? (And Can it Get You Out of Debt?
Annuities are insurance products that are usually used to enhance your retirement’s financial goals and plans. Overall, in terms of financial security, annuities are among the most powerful tools available....
Annuities are insurance products that are usually used to enhance your retirement’s financial goals and plans. Overall, in terms of financial security, annuities are among the most powerful tools available.
Unlike other retirement vehicles, annuities guarantee a lifetime income. As such, they’re a probably way to supplement other retirement income streams like a 401(k), IRA, and Social Security. But, is it possible to use an annuity to pay off your debt?
The short answer? Yes. In fact, when it comes to annuities, you can use them to purchase a home or business. What’s more, you can use the cash from your annuity to;
- Pay off medical bills. Expenses associated with medical treatment are one of the most common and unexpected expenses a person may encounter. In fact, medical debt is the most common reason for personal bankruptcies in the United States.
- Eliminate credit card debt. A typical U.S. household owes $6,270 in credit card debt. If you have a mortgage, car payment, and student loan, it’s not difficult to find yourself stuck in a debt cycle.
- Settle student loans. Borrowers with federal loans owe an average of $36,510 per person.
- Fund a divorce. Getting divorced isn’t just emotionally draining, it’s also financially devastating for both parties. Besides feeling you’re out of pocket financially, there are legal fees, child support payments, and perhaps even therapy costs.
At the same time, annuities have been designed to be long-term investments. As such, financial penalties may be imposed if you cash out your annuity early. So, this decision shouldn’t be taken lightly.
The good news? If you want to get out of debt, there might be ways to do so without facing hefty fees.
A Rapid Annuity Recap
In order to understand how money can be taken out of an annuity, let’s first have a quick overview of what an annuity is. Essentially, an annuity is a self-funded pension.
To buy an annuity, you deposit money with an insurance company. These payments can either be with a lump sum payment or through a series of monthly payments. And, the annuity company reimburses you later after it has grown significantly.
Annuities come in a variety of types, each offering unique characteristics for individuals with varying financial circumstances. Furthermore, your withdrawal method will depend on what type of annuity you have.
The following is a quick overview of annuities and their payout schedules;
- Immediate annuities. You begin receiving payments as soon as you purchase them. Typically, they benefit retirees who have already retired or are very close to retiring.
- Deferred annuities. Over time, you will earn interest on your money before receiving it. After the term expires, you can choose to enter a new guaranteed term, annuitize, or cash out.
Annuities also let you choose how you want your money to grow;
- Fixed annuities. This type of annuity provides a minimum guarantee of interest. The value of your account will grow according to your selected term with this annuity. A fixed annuity is considered the safest and most predictable option.
- Variable annuities. Rates are based on stock market performance. Generally, these are invested in mutual funds and can be riskier than fixed annuities. It’s even possible to lose money with this type.
- Fixed indexed annuities. This is a hybrid of a variable and a fixed annuity. Typically, they pay an interest rate that is based on the performance of your chosen market index, along with a minimum interest rate fix — typically 0%. As a result, you’ll never lose any of your premium. However, you might not have any gains either
It’s not usually possible to withdraw money from immediate annuities before a specific period of time. Once you pay the insurance company the lump sum payment, they will pay you back in a monthly stream of income for a specific timeframe. After selecting, this can’t be changed. Because of their inability to be cashed out early, immediate annuities are not subject to early withdrawal rules.
It is, however, feasible to withdraw money before they start paying you back with most deferred annuities. And, this is true whether if the annuity is fixed, variable, or fixed index. Therefore, early withdrawals from annuities like these are subject to these rules.
With that out of the way, let’s examine the three ways you can take money out of your annuity.
Make an Early Withdrawl
If you plan to withdraw money from an annuity, make sure you review its rules and federal law first. To illustrate, if you withdraw before you reach age 59 ½, Uncle Sam will charge you a 10% early withdrawal penalty. Also, this will be in addition to the regular income tax on your investment earnings. It’s important to know that the amount you contributed to your annuity will not be taxed.
You probably will have to pay the insurer a surrender charge if you withdraw from your annuity within the first five to seven years after purchasing it. Withdrawal charges typically are 7% of your withdrawal amount after just one year. However, they gradually decline by one percentage point each year until they reach zero after years seven and eight.
Moreover, certain annuities can come with a 20% surrender charge upon initial purchase. However, be sure to check your plan’s terms, because some annuities allow withdrawals of up to 10% without any surrender charges.
Does this mean you’ll always be penalized if you make an early withdrawal? Not necessarily.
In certain circumstances, some insurance companies will waive surrender charges. As an example, you can purchase a waiver of surrender charges (WSC) rider. If you are suffering from a chronic, terminal illness, or are confined to a nursing home, the rider allows you to access your funds penalty-free.
Additionally, some annuity contracts include free annuity withdrawal provisions. In this situation, you’re permitted to withdraw a portion of your fund each year without being charged surrender fees. The typical amount is 10% of the total value of your annuity contract.
But, if you want to avoid penalties altogether, you should wait until the surrender period expires.
Sell Your Annuity For Cash
If you want to sell your annuity, you have three options: a partial sale, a complete sale, or a lump sum sale. But, how do they compare?
Partial annuity sale.
Your payments from your annuity are sold for a set length of time. Let’s say you have a life annuity that covers you for the rest of your life, and you’re 40. It’s possible for you to sell the payments for five years. You will, however, continue to receive periodic annuity payments after that five-year period ends.
With this option, you don’t permanently forfeit annuity payments. Rather, you put them on hold so that you can get immediate cash. When you retire, you can still get money from the annuity to help you meet your current financial needs.
This is similar to the sale of a partial interest. The annuity can still provide payments to you in the future. In this case, however, you sell a lump sum of the annuity payout you are entitled to receive, not your annuity payments. Therefore, if you owe $25,000 on a student loan, for example, you could sell that amount of benefits in one lump sum.
With this option, you can decide how much cash you’ll receive and how much will be paid out. You may get a lower payout amount with a partial sale, depending on how many payments you skip. And, you’re assigned an exact dollar amount that you wish to receive in cash when you sell a lump sum.
Finally, when you sell an annuity in its entirety, you give up your remaining interest in it. Due to this, the remaining payments from the contract are all paid in one shot, without any future installments. Selling your annuity this way is easy since no lump sum or partial payment terms need to be negotiated.
You should choose the right option based on your current and future needs for cash. An entirety sale could help you meet other financial goals if you’ve saved enough money for retirement, for instance. A partial or lump sum sale, however, could maintain your annuity income stream once you retire if you got a late start on saving.
Also, be aware that there’s a legal process involved when selling an annuity. As such, you soul speak with your financial advisor and research companies that buy annuities. Taking these steps ensures that you’re making the right and legal financial move and are getting a fair price on your annuity.
One more thing. This process will take roughly four weeks.
Annuity sale cautions.
There are a couple of precautions to be aware of if you sell your annuity.
The first issue is that you may face tax consequences. Annuity payments, such as those received when you receive a guaranteed income annuity, would be subject to ordinary income tax when you receive them. So, you would owe the same amount of tax as if you were receiving a regular distribution.
Another consideration? The fees you’ll have to pay. Usually, this is the discount rate. To profit from a transaction, buyers charge a fee in return for upfront cash. Among other factors, predicted future interest rates affect the discount rate.
Finally, you might have better options to weigh. For example, 401(k) plans, whole life insurance policies, and personal loans are often less expensive alternatives. While the annuity is in its accumulation phase, small, penalty-free withdrawals may be permitted. Moreover, tax consultants recommend consulting with a tax adviser before making any decisions since a sale will have tax implications.
Take Out an Annuity Loan
When an annuity holder takes a loan against the value of his/her contract, it’s known as an annuity loan. By using this method, people can access funds without cashing out their annuities, which may expose them to taxes and penalties.
When can you take out an annuity loan?
Deferred annuities require the annuitant to pay regular payments to their insurance company in order to purchase the annuity contract as a whole. A fixed amount of money will be paid to that person each month once they reach retirement age, which again is currently 59 ½.
However, individuals can borrow against the cash value of their annuity contracts before they reach retirement age, but the loan must be repaid-with interest over a set period of time. In most cases, this five years.
How does the loan process work?
Before annuity loans can be initiated by the borrower, a request must be submitted to the insurer. Once the loan is approved, the borrower/annuity holder receives a lump sum. And, payments must continue to be made until the balance is repaid.
Generally, annuity providers will allow their clients to borrow 50% of their annuity value. It’s important to research the available options since each annuity provider has its own terms and conditions.
What are the advantages of borrowing against your annuity?
An annuity loan comes with the benefit of avoiding surrender charges. When an annuity contract is opened, it carries a surrender charge if it is canceled within a specified time period. Any gains accrued through the use of the annuity can sometimes be erased by surrender charges. On the other hand, annuity loans do not require surrender charges.
Moreover, the borrower does not have to pay taxes or pay early distribution penalties. If the annuity holder sold their annuity before they reached age 59 1/2, they would have to pay a 10% penalty for “early distribution.” Again, there will be tax consequences of selling the annuity. But, you can avoid these charges by taking out an annuity loan.
What are the disadvantages?
There are some drawbacks to an annuity loan, even though it can be a convenient way to get cash quickly. The borrower can be subject to an early distribution penalty, usually 10%, if he/she doesn’t repay the loan within the specified time frame. In addition, a borrower may lose out on potential earnings if they borrow money against an annuity. Borrowing money against an annuity may also hinder the capital growth of the investment.
The Bottom Line
While it is possible to use your annuity to get out of debt, this should be considered a last resort. After all, there are penalties and tax ramifications involved. Moreover, this could deplete your retirement savings making it more difficult to enjoy your golden years.
With that in mind, if you want to get out of debt, you should calculate your debt and devise a plan. One example would be the snowball method where you tackle your smallest debt first. Once paid off, you can throw those savings onto your next debt obligation.
You should also create a budget and stick to it. It’s a simple and effective way to reduce unnecessary spending. Once again, the money you save can be put towards your debt. Another suggestion would be negotiating better rates with your creditors. And, if you’re able, consider tapping into another income source, like a part-time job or side hustle.
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