Qualified vs. Non-Qualified Annuities

An annuity is a financial contract between an individual and an insurance company. Despite the array of structures and features to choose from, all annuities share a fundamental similarity: They involve an upfront payment by the purchaser in exchange for a series of guaranteed income distributions from the insurance company.

In the United States, all annuities are allowed to grow tax-deferred, which means investment earnings are not taxed until they are paid out to the purchaser. However, there are IRS rules that govern if and when annuity taxes are due on the premium, which is the money you used to purchase the annuity.

These rules are characterized by the terms qualified and non-qualified. Qualified and non-qualified annuities differ in a number of ways — most importantly in how they are purchased and taxed.

A qualified annuity allows for a tax-deductible purchase (made with pre-tax dollars), while a non-qualified annuity involves a purchase made with money which has already been taxed. Moreover, when you receive a distribution from a qualified annuity, the entire amount — premium and earnings — is subject to ordinary income tax. With a non-qualified annuity, only the earnings component is taxable since you already paid tax on the money used to make the purchase.

Another important distinction relates to the money used to purchase the annuity. A qualified annuity can only be purchased with money from another type of qualified vehicle, such as a regular 401(k) plan or a traditional individual retirement account (IRA). An annuity purchased with a non-qualified source of money is automatically classified as non-qualified.

A qualified annuity is a tax-advantaged financial product that can help you save for retirement. This is because the premium is allowed to grow tax-deferred, which can have a powerful cumulative effect over time.

You won’t pay taxes on the premium or the accumulated earnings until your annuity begins paying out, which usually occurs in retirement. However, the money used to purchase a qualified annuity must come from another source of IRS-qualified funds.

In addition to the funding source restriction, the IRS limits how much you can contribute to a qualified annuity annually. The limit depends on your income and the extent to which you participate in other qualified savings plans.

Withdrawals prior to age 59 1/2 are subject to a 10% IRS penalty, while distributions are mandatory at the age of 70 1/2 (or 72 if the owner reaches age 70 ½ after December 31, 2019). All distributions are subject to ordinary income tax, regardless of what age you take them.

It’s worth noting that in certain situations, the money in a qualified annuity can be transferred into a similar qualified annuity without triggering a tax liability. This transaction is known as an IRS 1035 exchange.

Like a qualified annuity, a non-qualified annuity is a tax-advantaged financial product that can greatly facilitate your retirement savings effort. However, while a qualified annuity is purchased with pre-tax money and subject to contribution limits, a non-qualified annuity is purchased with after-tax dollars with no contribution limits.

As a result, the purchase of a non-qualified annuity is not connected to IRS-qualified plans, such as 401(k) plans and traditional IRAs. The money used to purchase a non-qualified annuity can come from anywhere. Common sources of funding include savings accounts, taxable brokerage accounts and inheritances.

Since the money used to purchase a non-qualified annuity has already been taxed, it will never be taxed again. However, accumulated earnings on the premium will be taxed when you begin taking distributions — unless the annuity was purchased within a Roth 401(k) plan or a Roth IRA. Earnings in Roth-style accounts are not taxable.

As with qualified annuities, non-qualified withdrawals prior to age 59 1/2 are subject to a 10% IRS penalty. However, unlike with qualified annuities, distributions are not mandated at the age of 70 1/2 (or 72 if the owner reaches age 70 ½ after December 31, 2019).

Finally, like a qualified annuity, a non-qualified annuity can be transferred via a 1035 exchange in certain circumstances.

Annuities are often purchased and customized to meet retirement objectives. For many retirees, these products provide a great way to achieve a guaranteed stream of income in a low-risk, hands-off manner.

Given their tax-deferred growth potential, both qualified and non-qualified annuities can facilitate saving for retirement. That said, there are a number of notable differences between these two types of vehicles, including tax deductibility, annual purchase limits, tax treatment of distributions and distribution requirements.

All of these factors need to be carefully evaluated before you purchase an annuity. If you opt to move forward, one day you will face another important decision: how to receive your distributions.

Depending on your unique circumstances, any of one of these options could be optimal. Be aware that the lump-sum payment option could result in a sudden and significant tax liability, while the payment stream alternatives will spread your tax liability over time.

Regardless of your situation, remember that annuities are just one way to plan for retirement. Consider talking to a financial advisor about all of the ways you can save and invest and whether an annuity is sensible for your financial circumstances.

As you work through the details, remember to keep your eyes on the big picture. Strive to implement all aspects of your plan in an integrated and complementary fashion, making sure all key decisions reflect consideration for your current financial position, projected cash flows and holistic financial strategy.

Incidentally, your strategy should reflect your tolerance for risk, which is influenced by your time horizon, liquidity needs and tax position. Your advisor can help you think through all of this and put you on a sensible path to retirement.