Non-qualified annuities have some unusual tax advantages. With these contracts, you invest money using after-tax dollars. The money in the annuity then grows tax-deferred, until the contract matures. At that point, called “annuitization,” you begin receiving payments from the annuity and pay taxes on the profits you receive. If you’re on the fence about whether an annuity is right for you then you may benefit from working with a financial advisor who can help you weigh the pros and cons.
What Is a Non-Qualifed Annuity?
An annuity is a form of financial contract used as an investment asset. They are typically issued by insurance companies. With this asset, you make an initial investment, either in a lump sum or through a series of payments over time. Then, later, you receive structured payments based on the money you invested and how much it grew.
Annuities come in a wide range of options. You can, for example, sign up for annuities on either a “term certain” or a lifetime basis. With a term certain contract, the annuity will pay out over a specific period. For example, you might receive monthly payments over five or 10 years. With a lifetime contract, the annuity will begin making payments when you enter retirement and will then continue making payments for the rest of your life.
You can also sign up for what are known as “qualified” or “non-qualified” annuities. A qualified annuity is one which the IRS accepts as a qualified, tax-advantaged retirement account. This means that you can take a tax deduction for the money you invest in this annuity, up to the annual limits that the IRS establishes. In this way, qualified annuities work very much like a 401(k) or an IRA.
Non-qualified annuities are contracts that the IRS does not classify as tax-advantaged retirement accounts. Although typically they are still lifetime contracts used as retirement assets you cannot take a tax deduction for the money you contribute to the annuity.
How Are Non-Qualified Annuities Taxed?
Non-qualified annuities have essentially three tax terms, which are:
1. Investment Stage: No Tax Benefits
When you invest in a non-qualified annuity, you do so with money that you’ve already paid taxes on. You can’t take a tax deduction for these contributions.
2. Growth Stage: Tax Deferred
Annuities work similarly to standard retirement accounts in that they are typically built on a series of underlying investments. Every annuity will hold different investments and manage its money differently, but they all look to grow your initial investment and use that growth to make payments once the contract annuitizes.
With a non-qualified annuity, the portfolio does not pay any taxes on its growth over time. This is an unusual feature of this asset. Ordinarily, an investment portfolio pays taxes on its growth, such as if it sells assets for a capital gain or collects dividends. This is true even if it immediately reinvests that money, which is why mutual funds and ETFs can trigger periodic tax events just by holding them.
Non-qualified annuities do not pay these taxes until payments begin, which can give them significantly more capital with which to grow. If you choose, you can also have extra time to allow a non-qualified annuity to grow, as these accounts are exempt from required minimum distribution (RMD) rules. This allows you to begin receiving payments at any age.
3. Payout Stage: Taxes On Profits
You pay taxes on the money you receive from a non-qualified annuity, whether that comes in the form of the contract’s structured payouts or through a withdrawal. This money is taxed as ordinary income, not as capital gains.
However, because you paid taxes on your initial investment, you are only taxed on the profits you make off a non-qualified annuity. This means that each payment you receive has two tax components. A portion of your payment is considered your principal and is untaxed. The rest of your payment is considered profit and you pay taxes on that.
While the IRS uses a relatively complicated process known as General Rule for calculating this, the nontaxable portion of your payments is based on the ratio of your investment capital to the annuity’s account balance. For example, if you invested $100 and the annuity’s balance is $1,000, around 10% of your payments would typically be untaxed.
For more details see IRS Publication 575, which explains pension and annuity taxation and IRS Publication 939, which explains General Rule.
This tax status also applies to any heirs or spousal beneficiaries. If your payouts under the annuity transfer, for example, to a spouse, they would pay income taxes on the portion of each payment attributed to profits. Depending on the nature of your annuity, it may also issue a lump-sum payment to your heirs after your death. This, too, would be taxed as income based on profits.
Bottom Line
Non-qualified annuities are a popular retirement asset that you fund with after-tax dollars. These accounts pay no taxes on their growth and you pay ordinary income taxes on all the money you collect in excess of your initial investments. Consider working with a professional if you would prefer to have your tax planning managed by someone else.
Tips for Tax Planning
- So are annuities right for you? Well, it depends. As with all retirement assets, the right answer is based entirely on your needs. You may want to hire a financial advisor to help you make the right retirement decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Annuities have become a hotly debated retirement asset in recent years. Advocates argue that their certainty is very valuable, while critics suggest that you lose money relative to investing in the stock market. If you’re considering buying an annuity, make sure you consider any potential tax consequences.
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