What is a Non-Qualified Annuity?
A non-qualified annuity is a retirement plan that you pay for with after-tax money. Non-qualified annuities are not tax-deductible. Also known as the “after-tax retirement annuity.”
- What is a Non-Qualified Annuity?
- Non-Qualified Annuity Features and Benefits
- Non-Qualified Annuities At A glance
- How is a Non-Qualified Annuity Taxed?
- Qualified Annuities vs. Non-Qualified Annuities
- Non-Qualified Annuity Features and Benefits
- Annuity 1035 Exchanges
- Related Reading
- Frequently Asked Questions
Non-Qualified Annuity Features and Benefits
- Purchased with after-tax funds
- No contribution limits
- Only your earnings are taxed as income; your principal is not
- No Required Minimum Distributions (RMD)
A non-qualified annuity is a type of investment you buy with the money you have already been taxed on. It is not connected to any retirement account, such as an IRA or 401K.
Related Reading: Qualified vs Nonqualified
Non-Qualified Annuities At A glance
| Variable Annuity | Fixed Index Annuity | Fixed Annuity | Immediate Annuity | Deferred Income Annuity | |
|---|---|---|---|---|---|
| Principal Protection | No | Yes | Yes | Yes | Yes |
| Access To Principal | Yes | Yes | Yes | No | No |
| Control Over Money | Yes | Yes | Yes | No | No |
| Tax-Deferred Growth | Yes | Yes | Yes | No | No |
| Guaranteed Growth | No | Yes | Yes | No | No |
| Guaranteed Income | Yes | Yes | Yes | Yes | Yes |
| Inflation Protection | Yes | Yes | No | Yes | Yes |
| Death Benefit | Yes | Yes | Yes | Yes/No | Yes/No |
| Long-Term Care Help | Yes | Yes | Yes | No | No |
How is a Non-Qualified Annuity Taxed?
All annuities are allowed to grow tax-deferred. This means any earned money on the investment is not taxed until paid out to the annuity owner. However, there are differences in how taxes are taken out in non-qualified annuities. Income distributed from non-qualified annuities is taxed in 2 distinct ways, LIFO and the Exclusion Ratio.
Withdrawals and Lifetime Withdrawals (Income Riders)
There are no taxes on the principal when money is taken via a penalty-free withdrawal or lifetime withdrawals from a non-qualified annuity. You have to pay taxes only if there are earnings and interest. You will follow the “last-in-first-out” (LIFO) protocol of the IRS if it’s a non-qualified annuity distribution.
Last-In-First-Out (LIFO) means any taxable earnings and interest is distributed to the annuity holder first. Once the interest and earnings are depleted, there are no taxes due.
- Traditional Withdrawals = Last-In, First-Out
- Lifetime Income = Last-In, First-Out
Annuitization
The IRS calculates how much of an annuitized annuity withdrawal is taxable. This calculation is called the exclusion ratio. This ratio calculation is based on the length of the annuity, the principal, and the earnings.
If a non-qualified annuity is set up to pay the owner annuitized annuity payments for their entire life, the exclusion ratio will consider their life expectancy. If they live longer than their calculated life expectancy, all annuity payments beyond that time period are taxed as income.
For example, if your calculated life expectancy is 82 years old, the exclusion ratio will determine how much of each payment from your non-qualified annuity will be considered taxable earnings until you turn 82. After the age of 82, all payouts from the annuity are considered taxable income.
- Annuitized Annuity Payments = Exclusion Ratio
- Structured Settlements
- Single-Premium Immediate Annuities (SPIA)
- Non-Qualified Longevity Annuities
Qualified Annuities vs. Non-Qualified Annuities
Qualified annuities are purchased with pre-tax funds, while non-qualified annuities are funded with money on which taxes have been paid.
When you withdraw money from a qualified annuity, all of it is taxed as regular income. But if you withdraw money from a non-qualified annuity, only the earnings are taxed as regular income.
Qualified Retirement Plans
- 401(k)
- TSA 403(b)
- SARSEP
- Tradition IRA
- SEP-IRA
- SIMPLE IRA
- Roth IRA
Qualified Annuity Features
- Funded with pre-taxed funds
- IRS Rules cap annual contributions
- Payouts are 100% taxable (except Roth IRA Annuity)
- Required Minimum Distributions must be withdrawn starting at age 72.
Non-Qualified Annuity Features and Benefits
- Purchased with after-tax funds
- No contribution limits
- Only your earnings are taxed as income; your principal is not
- No Required Minimum Distributions
Annuity 1035 Exchanges
A 1035 annuity exchange is a rule under Section 1035 of the Internal Revenue Code that allows for a tax-free exchange of a life insurance or annuity policy for a different annuity contract better suited to an owner’s needs.
When transferring from one plan to another via a 1035 exchange, the transfer must be “like-to-like.” This means the annuity owner, annuitant, and the beneficiary must be the same during the exchange. Changes to the annuity contract can be changed AFTER the 1035 exchange is completed.
Annuity companies make this transfer easy for applicants by filling out a 1035 exchange form. Do NOT cash out the old annuity, then purchase a new annuity as this would qualify as taxable income with the IRS. You must use a 1035 exchange form.
1035 Exchange Examples
- Non-Qualified Annuity exchanged for Non-Qualified Annuity = OK
- Inherited Non-Qualified Annuity exchanged for Non-Qualified Annuity = OK
- Life Insurance Policy exchanged for Non-Qualified Annuity = OK
- Non-Qualified Annuity exchanged for Life Insurance Policy = Not OK
- Non-Qualified Annuity exchanged for Qualified Annuity = Not OK
Why 1035 Exchange Annuities?
Possible reasons for such transfers could be:
- An annuity owner might want a higher interest rate or premium bonus.
- The insurance company may not be financially strong.
- A new annuity contract may offer desirable features such as an enhanced death benefit or guaranteed lifetime income.
- A new annuity could provide more upside potential or more guaranteed income.
- The annuity owner may want to eliminate risk (variable annuity) and move into a safer annuity (fixed index annuity).
- The new annuity contract may have lower fees.
Related Reading
Frequently Asked Questions
How Are Non-Qualified Annuities Taxed?
Non-qualified annuities are taxed by the IRS in two different ways depending on how the income is received. If a withdrawal is made or lifetime withdrawals from an income rider are paid out to the annuity owner, the income will be taxed and LIFO (Last In, First out) will be used, which means the interest will be drawn first before your investment. If an income is annuitized, the exclusion ratio method is used to tax proportionately (your investment/interest earned) the annuity payments.
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