Non-qualified annuities are purchased with after-tax dollars that were not from a tax-favored retirement plan. Non-qualified annuity premiums are not deductible from gross income, meaning any earnings on the investment will be taxable.
The After Tax Retirement Annuity:
- Offers saving for retirement without contribution limits
- Tax-deferred growth on earnings only
Non-qualified annuities are an option for more conservative investors who want the potential of tax-deferred earnings and predictable retirement income.
Pre-Tax Contributions or After-Tax Contributions?
- Pre-taxed Contributions = Qualified Annuities
- After-taxed Contributions = Non-Qualified Annuities
Pre-Tax Contributions
Qualified is just an IRS term for funding with pre-tax dollars. This means that a contribution itself may be deductible, lowering taxable income. But when you take distributions from a qualified annuity, the entire distribution amount (contributions and earnings) will be subject to ordinary income taxes.
After-tax Contributions
A non-qualified annuity is funded with after-tax money. This means that you have already paid taxes on the money before putting it in the annuity. When you take out money, only the earnings are taxable as ordinary income.
Qualified Annuities vs. Non-qualified annuities
| Non-Qualified Annuity | Qualified Annuity |
|---|---|
| Only Earnings Are Taxed | Entire Amount Is Taxed |
| After-Tax Contributions | Pre-Tax Contributions |
| No Income Requirements | Only Earned Income Contributions |
| No Contribution Limits | IRS Contribution Limits |
| No Required Minimum Distributions | Income Must Start At Age 73 (RMDs) |
Related Reading: Qualified vs Non-Qualified Annuity
Non-qualified Tax Advantages
- An additional income stream in addition to Social Security when you retire
- The interest earned is not taxed until withdrawals are taken
- There are no age limits on contributing to the annuity
- No Required Minimum Distributions (RMD) at age 73
Non-Qualified Annuity Taxation
When you choose to withdraw your money from a non-qualified annuity, there are three common methods of receiving the distribution.
- A Lump-Sum Payment: Cashing in the entire annuity in a lump sum.
- Systematic Withdrawals: Automated penalty-free withdrawals
- Lifetime Withdrawals: An income for the rest of your life, even after the annuity runs out of money.
- Annuitization: An irrevocable fixed amount of income for a certain period of time
Annuitization Vs. Withdrawals
Lifetime withdrawals from an income rider and annuity payments from annuitizing your contract are 2 different methods of generating income from an annuity.
- The exclusion ratio will be applied if you annuitize the contract.
- LIFO (Last In, First Out) will be applied if you pocket lifetime withdrawals.
Exclusion Ratio
The IRS determines how much of the money that you take out of your annuity is taxable. They do this with a calculation called the exclusion ratio. This is based on how long your annuity was, how much money you paid in, and how much money you got out.
If a non-qualified annuity pays the owner payments for their entire life, the exclusion ratio will take their life expectancy into consideration. All payments beyond the annuitant’s life expectancy are taxed as income.
Last In, First Out (LIFO)
LIFO basically means any interest credited is applied to your annuity “Last,” and your original investment is applied to your annuity “First.” With LIFO, your interest will come out first via withdrawals.
In a nutshell, you haven’t paid taxes on the interest you’ve earned thus far. When you take income from your nonqualified annuity, the IRS wants the taxes paid on the interest first.
This means 100% of your retirement income (monthly, quarterly, semi-annual, or annual withdrawals) is 100% taxed until you’ve exhausted all of your gains from the annuity.
After you have exhausted all of your gains, your withdrawals are not taxable.
1035 Exchanges
With non-qualified annuities, you can exchange funds between different deferred annuity types without facing an early withdrawal penalty because the exchanges are covered by Section 1035 of the Internal Revenue Code. These transfers are known as 1035 exchanges.
Possible reasons for a 1035 transfer could be
- Fixed annuity owners might be more interested in an annuity with a higher interest rate.
- The current annuity company may be financially unstable.
- A new annuity contract may be more desirable because it offers benefits such as an enhanced death benefit or guaranteed minimum income.
- The new annuity may have lower fees.