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Couple inheriting a qualified annuitySomeone who inherits a non-qualified annuity will only have to pay income taxes on any earnings from the annuity when they are withdrawn. Inheriting a qualified annuity, on the other hand, means owing taxes on any withdrawals from the annuity, including principal and interest. The difference stems from the way the two types of annuities are funded. Qualified annuities are funded with pre-tax dollars, while non-qualified annuities are funded with after-tax dollars. This difference affects many aspects of how the two types of annuities can be used for retirement planning.

A financial advisor can help you handle an inherited annuity, whether it’s qualified or not. Find an advisor now.

Annuity Basics

Annuities are contracts between insurance companies and individuals that are often used in funding retirement. In return for a hefty payment from the individual, also known as the premium, the insurance company promises to make payments on a monthly or other regular basis.

The payments from an annuity can start immediately or at a set future date. They may last for a fixed number of years or for the annuity buyer’s lifetime. Lifetime annuities can provide retirees with guaranteed income, no matter how long the retiree lives.

The terms of an annuity typically call for payments to end when the owner dies. However, provision can be made for a remaining balance to be passed to someone else. This lets the owner designate someone to inherit the remaining annuity payments.

There are many types of annuities. Some provide fixed returns, while returns on others may vary according to stock market indexes or other benchmarks. One important way they can be divided is by whether they are qualified or non-qualified.

Comparing Qualified and Non-Qualified Annuities

Man icon next to upward facing arrowsQualified annuities are funded with pre-tax dollars, similar to contributions to IRAs or 401(k) plans. Any withdrawal from a qualified annuity is taxed at the owner’s individual rate in effect at the time of the withdrawal. The IRS limits the annual amount that can be put into a qualified annuity. And, like other tax-advantages retirement vehicles, owners of qualified annuities have to take required minimum distribution (RMD) withdrawals starting at age 70.5.

Non-qualified annuities are funded with money that has already been taxed. Instead of paying taxes on all withdrawals from the annuity, owners pay taxes only on the earnings. Since the money used to pay the principal or premium has already been taxed, it can be withdrawn later tax-free. The IRS doesn’t limit contributions, although the insurance company may place a cap on the size of the contribution, which is also called the premium.

Instead of paying taxes on all withdrawals from a non-qualified annuity, owners pay taxes only when withdrawing the earnings. Since the principal or premium has already been taxed, it can be withdrawn later tax-free. Also, non-qualified annuities don’t have to make RMDs.

Non-qualified annuities are similar to Roth IRAs. For instance, both types of retirement planning vehicles are funded with money that has already been taxed. Also, there are no RMDs on either Roths or non-qualified annuities. One difference is that when a Roth IRA holder withdraws from the account, any earnings are not taxed at the recipient’s regular rate. Earnings are taxed like normal income when withdrawn from a non-qualified annuity.

Taxing Inherited Non-Qualified Annuities

Someone who inherits a non-qualified annuity will have to pay taxes on withdrawals of the earnings but not the principal, just like the original owner would. This also applies to penalties on early withdrawals from the annuity.

If you withdraw money from an annuity before age 59.5, the IRS charges a 10% early withdrawal penalty. However, this penalty is only levied on early withdrawals of earnings on a non-qualified annuity, while a qualified annuity holder pays the 10% penalty on any withdrawals.

The IRS uses a formula to determine what part of a withdrawal is taxable earnings or tax-free principal. This is called the exclusion ratio. It’s based on the relationship between the initial premium and the total estimated payout of the annuity.

The exclusion ratio formula divides the initial premium by the total estimated payout. For instance, if you buy a $50,000 annuity that is expected to pay $100,000 over the life of the annuity, the exclusion ratio is $50,000 divided by $100,000 or 50%. This means that 50% of the monthly payout from the annuity would be taxed as earnings and 50% would be untaxed.

Bottom Line

Pregnant Asian womanInheritors of non-qualified annuities purchased with pre-tax funds must pay income taxes only on the earnings when making withdrawals from the annuity. The initial principal used to purchase the annuity has already been taxed, so those withdrawals are tax free. Inheritors of qualified annuities have to pay income taxes at their normal rate on all withdrawals, including both principal and any earnings. The IRS uses the exclusion ratio to determine which portions of a withdrawal consist of taxable earnings or non-taxable principal.

Tips on Annuities

  • Choosing an annuity requires carefully considering taxes, retirement needs and overall financial goals. That’s where a financial advisor can be valuable. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
  • Don’t forget to integrate Social Security payments into your retirement plans. While they may not have a monumental effect on your finances in retirement, they can provide you with some extra cash at a time when you’ll need it most. To gain some insight into what you can expect from this government program, take a look at SmartAsset’s Social Security calculator.

Photo credit: ©iStock.com/djiledesign, ©iStock.com/yasadesign, ©iStock.com/AsiaVision

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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