Non-Qualified Annuity: What You Need To Know

When it comes to retirement planning, there are a lot of different options to choose from. One option that may be unfamiliar to some is the non-qualified annuity. So let’s take a closer look at this and how the retirement plan works.

“A non-qualified annuity is an after-tax investment, which means you have paid taxes on the money before it enters the annuity. When you withdraw money from the retirement plan, only the earnings are taxable as regular income.“

What is a Non-Qualified Annuity?

An annuity that is not qualified is a retirement savings product you can only fund with after-tax dollars. The money in the annuity grows without being taxed, so you don’t have to pay any taxes until you take the money out of the annuity. When you finally take distributions from the account, you will only be taxed on your earnings; this is because when you originally made contributions to the account, you paid taxes then.

For example, you may have maxed out your 401k and Roth IRA but desire to put more money towards retirement. So an annuity is purchased outside your employer’s retirement plan, and deposits are made into it yearly. Like other retirement plans, penalty-free withdrawals can be made when you turn 59 1/2.

With an annuity, you can start taking withdrawals after a specific age or annuitize it and receive payments. If you take withdrawals, the taxes will be based on a last-in-first-out basis (LIFO). So if your overall gains are $25000,000 and you withdraw $500,000, the first $250,000 will be taxed since those are considered your “gains” or what was deposited last.

If you choose to annuitize and receive payments over time, you’re only taxed on a part of each distribution. The IRS considers this as a return on gains and the original investment.

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 an 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

How Non-Qualified Annuities Work

Non-qualified annuities provide tax-deferred investment opportunities for individuals who want to reduce their tax bill in retirement. Not to mention, if you choose to annuitize or add a guaranteed lifetime withdrawal benefit (GLWB), they can provide a guaranteed payment each month during retirement.

Annuities have two clear phases: the accumulation phase and the distribution phase. During the accumulation phase, you make contributions which then grow based on how it’s invested. The distribution stage is when you receive distributions either through self-directed withdrawals or scheduled annuity payments.

How your annuity is structured will determine what happens to the leftover money once you die. If you want someone else to receive payments after your death, make sure that you choose a payout that allows for it. If you chose the lifetime withdrawal benefit option, whomever you named as beneficiary or estate will inherit the remaining value of your annuity.

Though the government has no restrictions on how much you can contribute to your non-qualified annuity, your insurance company may. Be sure to check the terms of your contract for more information.

If you cash out your non-qualified annuity before age 59 1/2, the IRS will charge a 10% penalty on the earnings (in addition to taxes).

Types of Non-Qualified Annuities

Here’s a brief overview of several types of non-qualified annuities you can purchase, depending on when you want to receive payments and how much financial risk you’re willing to tolerate.

Immediate and Deferred

With an immediate annuity, you make a lump-sum payment upfront and then start receiving payments soon after. With a deferred annuity, your money grows over time before you make withdrawals or annuitize. You can purchase a deferred annuity with contributions made over time or with one initial lump sum.

Fixed, Variable, and Indexed

Depending on your level of financial risk tolerance, there are several different types of non-qualified annuities available.

A fixed annuity provides a guaranteed interest rate set by the insurance company. This generally tends to be a low-risk investment, providing stability and security for individuals who don’t want to gamble with their money.

Variable annuities are a type of investment that involve stocks and bonds. Even though they may lose money due to market conditions, they’re still worth it for people who don’t mind taking risks.

If you want a higher rate than what a fixed annuity offers without the market-based risk of a variable annuity, then a fixed-indexed annuity (equity-indexed annuity) may be right for you. With this type of annuity, you gain upside growth based on market performance while avoiding downside risk with negative returns.

Although FIAs will not lose you money based on market performance, some of that growth may be capped. However, most indexed annuities today offer no caps. In addition, if the market benchmark does poorly, fees associated with the account can take away from your total value.

Non-Qualified Annuities At A glance

How is a Non-Qualified Annuity Taxed?

All annuities are allowed to grow tax-deferred. 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, suppose your calculated life expectancy is 82 years old. In that case, 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, 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
• Traditional 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 beneficiary must be the same during the exchange. 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:

• First, 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.
• Fourth, the annuity owner may want to eliminate risk (variable annuity) and move into a safer annuity (fixed index annuity).
• Finally, the new annuity contract may have lower fees.

Next Steps

If you are interested in purchasing an annuity, it is important to understand the difference between qualified and non-qualified annuities. Qualified annuities are funded with pre-tax dollars, while non-qualified annuities are funded with after-tax dollars. Contact us today for a quote on a qualified or non-qualified annuity that meets your needs.

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Frequently Asked Questions

Related Reading

• What is a Qualified Annuity?
• What is an Annuity Fund?
• 401(k) Calculator: Estimate Tax-Deferred Retirement Income Up To Twenty Years In The Future
• Roth IRA Calculator: Turn Your Retirement Plan Into Tax-Free Income That You Can’t Outlive
• Traditional IRA Calculator: Estimate Savings Growth And Income, Then Reconsider A Non-Qualified Annuity