Annuities can be a source of guaranteed income for retirement, as well as a way to schedule payments from a structured settlement. They may be categorized as qualified or non-qualified annuities. If you’re thinking of adding an annuity to your financial plan, here’s what you need to know about qualified vs. non-qualified annuities.
What are Non-Qualified Annuities?
Before digging into non-qualified annuities, here’s some background on what annuities are and how they work. When you purchase an annuity, you’re essentially purchasing an insurance contract from an insurance company. You pay the insurer a set amount of money for the annuity contract and in return, the insurance company makes payments to you.
Those payments can be deferred, meaning they begin at a set date in the future, or immediate with payments beginning right away. Payments can last for a fixed period of time or be guaranteed for life. Annuities can be partially or fully sold for cash or you can pass an annuity on to someone you choose to inherit it. For example, you could set up an annuity to continue making payments to your spouse once you pass away.
Non-qualified annuities use after-tax dollars for funding. Consequently, you’ve already paid taxes on the money you purchased it with. There are no required minimum distributions for non-qualified annuities. In both those respects, it’s similar to a Roth individual retirement account.
Unlike a Roth IRA, however, any earnings withdrawn from non-qualified annuities are taxable at your regular tax rate. The IRS doesn’t limit how much you can contribute to a non-qualified annuity each year, although the insurance company you buy the annuity from may set an annual cap on contributions.
What are Qualified Annuities?
A qualified annuity differs vastly from a non-qualified annuity. Pre-tax dollars fund both annuities. Typically, you can invest in a qualified annuity through your employer’s retirement plan or a traditional IRA.
Qualified annuity contributions depend on your income and eligibility for other qualified retirement plans. The required minimum distribution rules that apply to traditional 401(k)s and IRAs, which require you to begin taking minimum distributions starting at age 70.5, also apply to qualified annuities.
Tax Treatment of Qualified vs. Non-Qualified Annuities
Qualified and non-qualified annuities each follow a different set of tax rules for distributions. With non-qualified annuities, only the earnings on your initial investment are taxable. You don’t pay taxes on the principal amount you used to purchase the annuity since that was after-tax money.
Qualified annuities, on the other hand, follow the same tax rules as the plan they’re purchased through. So if you invest in a qualified annuity through a traditional 401(k) or IRA, the IRS taxes it like ordinary income upon withdrawal. Like 401(k)s and IRAs, the minimum age threshold to make qualified withdrawals is 59 1/2.
With both types of annuities, an early withdrawal penalty may apply if you take money out of the contract before age 59 1/2. If you’re withdrawing money early from a qualified annuity, the entire amount (earnings and principal) would be subject to ordinary income tax. The earnings portion of the withdrawal would also trigger a 10% early withdrawal penalty.
Withdrawing money early from a non-qualified annuity can also result in owing the 10% early withdrawal penalty on earnings. Exceptions to this rule include early withdrawals made because you’ve become permanently disabled or you pass away. A work-around for avoiding the early withdrawal penalty is also available if you’re transferring money from one type of non-qualified annuity to another.
You could face an additional penalty if you have a qualified annuity and don’t take required minimum distributions (RMDs) as scheduled. Skipping an RMD yields a 50% penalty on the required withdrawal.
Which Type of Annuity Is Better?
Whether you should purchase qualified or non-qualified annuities depends on your tax situation, retirement needs and financial goals.
Here’s a rundown of the benefits non-qualified annuities could offer:
- Earnings grow tax-deferred.
- Only earnings are taxable as income.
- No required minimum distributions at age 70 1/2.
- No annual contribution limit.
If you expect to be in a higher tax bracket at retirement or you’d like to be able to contribute to an annuity indefinitely, then non-qualified annuities might be preferable. On the other hand, a qualified annuity could offer these benefits:
- Paying premiums with pre-tax dollars.
- Growing contributions and earnings tax-deferred.
You might consider a qualified annuity if you expect to be in a lower tax bracket when you retire, since you can defer taxes on contributions and earnings. A qualified annuity could also offer other benefits beyond guaranteed income, such as a death benefit payable to your spouse or another beneficiary.
How to Choose an Annuity
If you’re considering an annuity as part of your long-term financial plan, it’s important to ask the right questions first.
- How much will or can you invest in the annuity?
- What type of tax treatment would work best?
- When do you need annuity payments to start?
- Will your annuity need to continue paying benefits to your spouse if you pass away?
- Is there a possibility that you might sell your annuity for cash at some point?
- What type of return do you need an annuity to generate?
These kinds of questions can help you narrow down your annuity choices. For example, you might prefer a fixed annuity if you want some predictability with investment returns and a lower level of risk. But if you’re comfortable taking on more risk for the chance to earn higher returns, you might try a variable annuity instead.
The Bottom Line
Tax treatment is primarily what separates qualified and non-qualified annuities. If you’re considering an annuity, it’s important to keep the contribution limits, required minimum distribution rules and tax rules. One type of annuity may be more beneficial than another in minimizing your tax liability as much as possible.
Retirement Planning Tips
- Annuities are just one way to plan for retirement. Consider talking to your financial advisor about other ways to save and invest and whether an annuity could make sense. If you don’t have an advisor, finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Wondering which annuities might be right for you? SmartAsset’s annuity reviews can help you find products that may fit your needs.
- If you decide to invest in an annuity, look at how it fits within your larger portfolio. For example, will you also need life insurance to provide financial security for your loved ones? If so, could you benefit more from a term or permanent life policy? Are you saving enough in your employer’s plan to reach your target retirement savings? And does an annuity require you to take on more or less risk in your portfolio? Thinking about the big picture can help ensure that you’ve covered all the bases when it comes to retirement planning.
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