What Is A Non-Qualified Annuity?

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

What Is A Non-Qualified Annuity?

A non-qualified annuity is an insurance product paid for with already taxed money. Unlike its counterpart, the qualified annuity, which is funded with pre-tax dollars and offers tax deductions, a non-qualified annuity does not provide upfront tax benefits. However, 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.

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. 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.

Understanding Non-Qualified Annuity Taxation

Exclusion Ratio

The exclusion ratio 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. For 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 This means the latest earnings (interest and growth) are considered to be withdrawn first before the principal amount.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.

Non-Qualified Annuity

Non-Qualified Annuity Pros and Cons

Pros:

  • Tax-Deferred Growth: Investments grow without immediate tax implications, potentially leading to more substantial gains.
  • No Contribution Limits: Unlimited annual investment, providing more flexibility than other retirement accounts like IRAs or 401(k)s.
  • No RMDs (Required Minimum Distributions): Greater control over retirement funds with no mandatory withdrawal age.
  • Estate Planning Flexibility: Non-qualified annuities can be an efficient way to transfer wealth to heirs.

Cons:

  • Taxation on Withdrawals: Withdrawn earnings are subject to ordinary income tax rates, potentially higher than capital gains rates.
  • Penalties on Early Withdrawals: Accessing funds before age 59½ may lead to a 10% penalty on the earnings.
  • Fees and Charges: These annuities may come with considerable fees, including commissions, surrender charges, and annual management fees.
  • Complexity and Variability: The array of options and contract riders can be overwhelming, and investment performance may fluctuate.

Non-Qualified Annuity Early Withdrawal Penalty

Non-qualified annuities are a popular investment choice because they allow your money to grow tax-deferred. However, they come with certain rules and penalties for early withdrawals.

Early Withdrawal Penalty For Non-Qualified Annuities

  1. 10% IRS Penalty:
    • If you withdraw funds from your non-qualified annuity before the age of 59 1/2, you will generally face a 10% early withdrawal penalty on the earnings portion of the withdrawal.
    • This penalty is in addition to the ordinary income tax you owe on the earnings.
  2. Ordinary Income Tax:
    • Regardless of age, any earnings you withdraw from a non-qualified annuity are subject to ordinary income tax. The principal or the amount you initially invested is not taxed again since it was funded with after-tax dollars.

Exceptions To The 10% Early Withdrawal Penalty

The IRS provides several exceptions to the 10% early withdrawal penalty for non-qualified annuities. You may avoid the penalty if the withdrawal is made under the following circumstances:

  • Disability: If you become totally and permanently disabled, you may withdraw funds without incurring the 10% penalty.
  • Substantially Equal Periodic Payments (SEPP): Withdrawals made as part of a series of substantially equal periodic payments based on your life expectancy can avoid the penalty. These payments must continue for at least five years or until you reach age 59 1/2, whichever is longer.
  • Death: The beneficiary can withdraw the funds without the 10% penalty if the annuity owner dies.
  • Qualified Domestic Relations Order (QDRO): Distributions made to an ex-spouse or dependent under a QDRO as part of a divorce or separation agreement can be exempt from the penalty.
  • Medical Expenses: If you incur medical expenses that exceed 7.5% of your adjusted gross income (AGI), you may be able to withdraw funds without penalty.
  • Annuity Payouts: Payments made as part of a lifetime annuity payout (annuitization) are not subject to the penalty, even if you are under 59 1/2.
What Is A Nonqualified Annuity?

Types Of Non-Qualified Annuities

How We Can Help

At The Annuity Expert, we understand the complexities and emotional challenges of planning for a secure financial future. As an insurance agency, annuity broker, and retirement planner for 15 years, we are dedicated to finding the best solutions at the lowest costs for our clients.

Your main problem is finding a way to maximize your retirement savings while minimizing tax burdens and avoiding penalties. The symptoms of this problem include confusion about investment options, anxiety about future financial security, and frustration with high fees and complex products. We recognize these challenges and are here to provide clarity and guidance.

We believe in helping you achieve financial freedom by providing personalized, expert advice that empowers you to make informed decisions. Our goal is to offer you peace of mind, knowing that your investments are working efficiently towards your retirement goals.

How Do Non-Qualified Annuities Work?

What We Recommend

To achieve your desired financial security, follow these steps:

  1. Initial Consultation
    • What Happens: We discuss your financial goals, current investments, and retirement plans.
    • Benefit: Personalized advice tailored to your unique needs and objectives.
  2. Customized Plan Development
    • What Happens: We create a detailed investment strategy that leverages non-qualified annuities to maximize tax-deferred growth.
    • Benefit: A clear, actionable plan designed to grow your retirement savings efficiently.
  3. Implementation and Ongoing Support
    • What Happens: We help you implement the plan, monitor its performance, and adjust as needed.
    • Benefit: Continuous support ensures your investments stay on track, giving you confidence in your financial future.

Features and Benefits:

  • Tax-Deferred Growth: Your investments grow without immediate tax implications, enhancing long-term gains.
  • Unlimited Contributions: Flexibility to invest as much as you want annually, surpassing traditional retirement accounts.
  • No RMDs: Greater control over your retirement funds without mandatory withdrawals.
  • Personalized Advice: Tailored strategies to meet your specific financial goals and needs.

Common Objections:

  • “I don’t understand annuities.”: We provide clear explanations and personalized guidance to demystify annuities.
  • “The fees seem high.”: Our comprehensive analysis ensures you receive the best value, balancing costs and benefits.
  • “What if the market crashes?”: Non-qualified annuities offer various levels of protection to safeguard your investment.

If you choose not to work with us, you risk missing out on valuable tax-deferred growth opportunities and personalized financial strategies that could significantly enhance your retirement savings. However, by partnering with us, you will experience peace of mind, knowing your investments are optimized for maximum growth and minimal risk.

Feel the confidence and security of a well-planned financial future. Contact us today for free advice or a quote, and take the first step towards maximizing your retirement savings.

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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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