Non-Qualified Annuities

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

What Is A Non-qualified Annuity?

A non-qualified annuity is an insurance product paid for with money that’s already been taxed. You can take money out at any age, but if you do so before you’re 59 ½ years old, you usually have to pay an extra 10% as an early withdrawal fee. Its strength lies in the tax-deferred growth of your investment. This means that while your money grows inside the annuity, you won’t owe taxes until you start making withdrawals.

Unlike its counterpart, the qualified annuity, which is funded with pre-tax dollars and offers tax deductions, the non-qualified version does not provide upfront tax benefits.

Non Qualified Annuities

Non-qualified Annuity Taxation

Understanding the taxation rules of non-qualified annuities is crucial. When you begin making withdrawals from your annuity, the earnings (or the growth portion) are taxed as ordinary income. The principal amount, which is the money you initially invested, is not taxed again since it was funded with after-tax dollars.

Exclusion Ratio

This is a method used to determine the taxable and non-taxable portions of your annuitized annuity payments. It’s a ratio that divides your investment (non-taxable) by the expected return (total of both principal and earnings). The result gives you the percentage of each withdrawal that is tax-free.

Example: If you invested $50,000 and expect a return of $100,000 over the annuity’s lifespan, the exclusion ratio is 50%. This means half of each payment you receive is tax-free.

Last-In-First-Out (LIFO)

When it comes to non-qualified annuities, the LIFO method is applied to withdrawals. This means the latest earnings (interest and growth) are considered to be withdrawn first before the principal amount. Since the earnings are taxable, early withdrawals might result in a larger tax bill.

This IRS taxation method applies to any withdrawals and any income from a lifetime income rider.

Example: If you decide to withdraw $5,000 from your non-qualified annuity, and your most recent earnings amount to $4,000, then $4,000 of your withdrawal will be subject to taxation.

Non-Qualified Annuity

Non-qualified Annuity Pros And Cons

Pros of Non-Qualified AnnuitiesCons of Non-Qualified Annuities
Tax-Deferred Growth: Investments grow without immediate tax implications, potentially leading to more substantial gains.Taxation on Withdrawals: Withdrawn earnings are subject to ordinary income tax rates, potentially higher than capital gains rates.
No Contribution Limits: Unlimited annual investment, providing more flexibility than other retirement accounts like IRAs or 401(k)s.Penalties on Early Withdrawals: Accessing funds before age 59½ may lead to a 10% penalty on the earnings.
No RMDs (Required Minimum Distributions): Greater control over retirement funds with no mandatory withdrawal age.Fees and Charges: These annuities may come with considerable fees, including commission, surrender charges, and annual management fees.
Estate Planning Flexibility: Non-qualified annuities can be an efficient way to transfer wealth to heirs.Complexity and Variability: The array of options and contract riders can be overwhelming, and investment performance may fluctuate.
How Do Non-Qualified Annuities Work?

Types Of Non-Qualified Annuities

  • Non-Qualified Fixed Annuities: You earn a steady amount of interest over time. Your money grows safely.
  • Non-Qualified Variable Annuities: Your money is put into investments like mutual funds. The value can go up or down based on how these investments perform.
  • Non-Qualified Indexed Annuities: Your returns are tied to a market index’s performance, like the S&P 500, but you have some level of protection against losses.
  • Non-Qualified Immediate Annuities: You give a company a lump sum of money, and they start paying you income right away for a certain period or life.
  • Non-Qualified Deferred Annuities: You put money into this annuity, and it grows until you’re ready to start taking income in the future.
  • Non-Qualified Longevity Annuities: You buy this annuity now, but it doesn’t start paying you back until later in life, helping you afford expenses if you live a very long time.
What Is A Nonqualified Annuity?

The Value of a Non-Tax-Qualified Annuity

A non-tax-qualified annuity can be an excellent tool for those looking for additional avenues to save for retirement beyond the traditional routes. Its strength lies in tax-deferred growth, allowing your money to compound without the annual tax drag. Moreover, there’s no limit to how much you can invest in a non-qualified annuity, unlike IRAs or 401(k)s.

Non-Qualified Annuity Taxation

Next Steps

In summary, a non-qualified annuity offers tax-deferred growth potential with no contribution limits, and only the interest is taxed. It can be particularly beneficial for those in high-income brackets or who have maxed out their other retirement-saving avenues. Contact us for a quote.

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Questions From Our Readers

Are RMDs required on non-qualified annuities?

No, RMDs are not required on non-qualified annuities. However, you may be subject to income tax on the amounts withdrawn.

Are there any penalties if I withdraw from the non-qualified annuity early?

Yes, early withdrawals before age 59½ typically incur a 10% IRS penalty on earnings, plus regular income tax on the gains.

What are the taxes owed on a nonqualified annuity to a beneficiary?

Taxes on nonqualified annuities inherited by a beneficiary depend on several factors, including the annuity’s value, the beneficiary’s tax bracket, and whether distributions are taken as a lump sum or over time. Generally, the beneficiary pays income tax on the earnings portion of distributions, while the original owner’s contributions are not taxed.

I will be withdrawing from my nonqualified fixed annuity for the first time at age 60. Will the taxes on the annuity be included in my federal income tax?

Yes, they will. Withdrawals from a nonqualified fixed annuity are subject to federal income tax. The earnings portion of your withdrawal is taxed as ordinary income. Since you are over 59½, you won’t face the 10% early withdrawal penalty typically applied to younger annuitants. The principal portion, which is the amount you initially invested, is not taxed as you’ve already paid taxes on this money.

I’m 58 and cashed out a non-qualified annuity that’s out of surrender to move the money into another annuity within a week. Should you still worry about a 10% penalty?

In this case, the 10% early withdrawal penalty does not apply because that penalty is specific to qualified accounts like IRAs for withdrawals before age 59½. However, for a non-qualified annuity, withdrawing funds can still lead to tax implications. To avoid these, it’s best to use a direct transfer between the insurance companies, known as a 1035 exchange. This method avoids taking direct possession of the funds, thus maintaining the tax-deferred status of the annuity and avoiding immediate taxation on any gains. Always consider completing a transfer form on the new annuity’s application to facilitate this direct transfer and avoid potential tax complications.

Can I cash out a non-qualified annuity?

Yes, you can cash out a non-qualified annuity, but be aware of potential surrender charges. These charges typically apply to the interest earned and vary depending on the policy terms.

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

Shawn Plummer is a Chartered Retirement Planning Counselor, insurance agent, and annuity broker with over 14 years of first-hand experience with annuities and insurance. Since beginning his journey in 2009, he has been pivotal in selling and educating about annuities and insurance products. Still, he has also played an instrumental role in training financial advisors for a prestigious Fortune Global 500 insurance company, Allianz. His insights and expertise have made him a sought-after voice in the industry, leading to features in renowned publications such as Time Magazine, Bloomberg, Entrepreneur, Yahoo! Finance, MSN, SmartAsset, The Simple Dollar, U.S. News and World Report, Women’s Health Magazine, and many more. Shawn’s driving ambition? To simplify retirement planning, he ensures his clients understand their choices and secure the best insurance coverage at unbeatable rates.

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

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