Non-Qualified Annuity: What You Need To Know

Shawn Plummer

CEO, The Annuity Expert

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.”

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 ProtectionNoYesYesYesYes
Access To PrincipalYesYesYesNoNo
Control Over MoneyYesYesYesNoNo
Tax-Deferred GrowthYesYesYesNoNo
Guaranteed GrowthNoYesYesNoNo
Guaranteed IncomeYesYesYesYesYes
Inflation ProtectionYesYesNoYesYes
Death BenefitYesYesYesYes/NoYes/No
Long-Term Care HelpYesYesYesNoNo

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

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

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

Non-qualified Annuities

Shop and compare non-qualified annuities to safely grow your retirement savings or generate a guaranteed income you can’t outlive.

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

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.

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.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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