Qualified Annuity: What Is It And How Does It Work?

Shawn Plummer

CEO, The Annuity Expert

There are several different types available on the market regarding annuities. But what is a qualified annuity, and how does it work? A qualified annuity is a specific annuity that offers tax-deferred growth potential. This means that you don’t have to pay taxes on your earnings until you start making withdrawals. Keep reading for more information on how these annuities work and whether or not they might be a good option for you.

What Is A Qualified Annuity?

A qualified annuity is an annuity that meets the requirements of Internal Revenue Code section 401(a) and is therefore eligible for certain tax benefits. Specifically, the funds held in a qualified annuity are not subject to income tax until they are withdrawn, and any earnings on the investment grow tax-deferred.

There are two types of qualified annuities: employer-sponsored annuities and individual retirement annuities (IRAs). Employer-sponsored annuities are typically set up as part of a retirement plan, such as a 401(k), while IRAs are opened and funded by individuals.

Qualified annuities have specific rules that must be followed to maintain their tax-advantaged status. For example, funds can only be withdrawn from a qualified annuity during retirement (generally after age 59½) or if the account holder dies, becomes disabled, or incurs certain medical expenses. Funds withdrawn before retirement will be subject to income tax plus a 10% early withdrawal penalty.

How A Qualified Annuity Works

A qualified annuity is a savings plan for retirement. You put in money before taxes. A non-qualified annuity is a saving plan for retirement that you put in post-tax dollars. The difference comes from the IRS.

Contributions to a qualified annuity are taken from your earnings and set aside in the retirement plan to grow. They do not become taxed until you take them out of the account in retirement. Contributions to a non-qualified plan are made with dollars already taxed.

The money you deposit into qualified annuities is not taxed each year income is not withdrawn. This allows your taxes to be lower for the year. However, you will need to pay taxes on your money and the interest earned when you retire.

While distributions and interest from a qualified annuity are taxed as ordinary income, distributions from a non-qualified annuity are not subject to any income tax on the contributions, only the interest earned.

Qualified Annuity Types

When your company offers you a retirement plan, there are many choices. The most common is the 401(k), 403(b) retirement plan, and an individual retirement account (IRA).

  • The defined benefit plan is a savings plan that dictates how much money the employer will give to you. The payment amount depends on the employee’s earnings history.
  • A 401(k) is a retirement plan that a for-profit company offers its employees. The SECURE Act now lets you include annuities in 401(k)s.
  • The 403(b) is available primarily to teachers, nurses and medical staff, public employees, and workers at tax-exempt organizations.
  • The IRA is a popular savings plan that allows a pre-tax contribution up to an annual limit.

An annuity may be qualified if it meets specific requirements and follows IRS regulations.

Related Reading: Non-qualified vs. qualified

What is the difference between a qualified and non-qualified annuity?

A qualified annuity is an annuity that meets the requirements of Internal Revenue Code section 401(a) and is therefore eligible for certain tax benefits. A non-qualified annuity does not meet these requirements and therefore does not offer the same tax advantages.

One key difference between qualified and non-qualified annuities is that the funds held in a qualified annuity are not subject to income tax until withdrawn. In contrast, the funds held in a non-qualified annuity are subject to income tax as soon as they are deposited. Additionally, any earnings on the investment grow tax-deferred in a qualified annuity, while earnings on a non-qualified annuity are taxed at the investor’s marginal tax rate.

What are the benefits of a qualified annuity?

The main benefit of a qualified annuity is that it offers tax-deferred growth on the investment. This means that the money invested in the annuity can grow without an income tax. Additionally, qualified annuities offer tax-deferred growth on any earnings from the investment.

Another benefit of qualified annuities is that they offer tax-advantaged status for retirement savings. This means that the money invested in a qualified annuity can grow without being subject to income tax until withdrawn. Additionally, any withdrawals from a qualified annuity after retirement are taxed as ordinary income.

Finally, qualified annuities offer estate planning benefits. The money invested in a qualified annuity is not subject to probate, which can be a lengthy and expensive process.

What are the disadvantages of a qualified annuity?

The main disadvantage of a qualified annuity is that it offers no immediate tax deduction for the investment. This means that the money invested in the annuity is subject to income tax in the year it is deposited. Additionally, any withdrawals made from a qualified annuity before retirement are subject to income tax and may be subject to a 10% early withdrawal penalty.

Another disadvantage of qualified annuities is that they are not as flexible as non-qualified annuities. For example, qualified annuities typically have more restrictions on when and how withdrawals can be made. Additionally, qualified annuities may have higher fees than non-qualified annuities.

How To Spend A Qualified Annuity Efficiently In Retirement

Employees can’t touch their qualified annuity plans without a tax penalty until they’ve reached the age of 59½ years. Annuities from previous employers can be rolled over or transferred to a better annuity that offers better features to maximize savings potential, principal protection, or guaranteed lifetime income. If a retiree is upon retirement, an annuity owner can transfer their current annuity into a new living benefit annuity. The annuity will then equally distribute a percentage of the annuity for the rest of the retiree’s lifetime or married retirees’ lifetimes, even after the account has run out of money.

Bottom Line

Annuities can be a great way to save for retirement and receive tax breaks. Contact us today for a quote if you’re interested in learning more about qualified annuities. Then, we’ll help you figure out whether this type of annuity is a good fit for your needs and goals. Thanks for reading!

What Is A Qualified Annuity And How Does It Work?

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Frequently Asked Questions

What are qualified vs. non-qualified funds?

Qualified funds meet the Internal Revenue Code section 401(a) and are therefore eligible for certain tax benefits. Non-qualified funds do not meet these requirements and do not offer the same tax advantages.

One key difference between qualified and non-qualified funds is that the funds held in a qualified account are not subject to income tax until they are withdrawn. In contrast, the funds held in a non-qualified account are subject to income tax as soon as they are deposited. Additionally, any earnings on the investment grow tax-deferred in a qualified account, while earnings on a non-qualified investment are taxed at the investor’s marginal tax rate.

Which of the annuities is a qualified annuity?

All annuities can be either a qualified or non-qualified annuity except a qualified longevity annuity contract which is always a qualified annuity, and a structured settlement is always non-qualified.

How do I know if my annuity is qualified?

The easiest way to determine whether your annuity is qualified is to check with the financial institution that issued the annuity. They should be able to tell you whether the annuity meets the Internal Revenue Code section 401(a) requirements.

Another way to tell if an annuity is qualified is to look at how the annuity is being used. For example, if the annuity is used to fund a qualified retirement plan, such as a 401(k) or IRA, it is likely a qualified annuity. On the other hand, if the annuity is being used for other purposes, such as to save for a child’s education, it is likely a non-qualified annuity.

What is better, an annuity or an IRA?

The answer to this question depends on the individual’s specific financial situation. Generally, an annuity is better for someone looking for a guaranteed stream of income in retirement, while an IRA is better for someone who wants more flexibility with their investments.

An annuity can offer several benefits, including tax breaks, a death benefit, and a guaranteed income stream for life. However, annuities have drawbacks, such as high fees and early withdrawal penalties.

An IRA can offer more flexibility than an annuity, allowing the account holder to choose how their money is invested. Additionally, IRAs typically have lower fees than annuities. However, an IRA does not offer the same guarantees as an annuity, and withdrawals from an IRA are subject to income tax.

Who can contribute to a qualified annuity?

Anyone can contribute to a qualified annuity, including the account holder, employer, and third-party organizations. However, only the account holder is eligible for the tax benefits associated with a qualified annuity.

Do you get 1099 for an annuity?

If you receive income from an annuity, you may be required to file a 1099-R form with the IRS. The 1099-R form reports distributions from retirement plans, including annuities.

Can I withdraw from my annuity before 59?

Yes, you can withdraw from your annuity before age 59, but there are consequences. You will typically owe income tax on the withdrawal portion considered earnings. The tax amount you will owe depends on your marginal tax rate. You may also be subject to a 10% early withdrawal penalty if you are younger than 59.

Can you roll over an annuity into an IRA?

Yes, you can roll over an annuity into an IRA. However, there may be some tax implications depending on your annuity type.

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 annuities subject to RMD?

The answer to this question depends on the type of annuity you have. If you have a qualified annuity, such as an IRA or 401(k), then the answer is yes, you are subject to RMD. However, if you have a non-qualified annuity, you are not subject to RMD. For example, if you have a Roth annuity, you are not subject to RMDs.

Is a non-qualified annuity a retirement account?

All deferred annuities, both qualified and non-qualified, are considered retirement accounts.

What is the taxation of qualified annuities?

The taxation of qualified annuities is relatively simple: the money you put into the annuity (up to the annual contribution limit) is deducted from your taxable income, and all of the earnings on the account grow tax-deferred. Then, when you start taking distributions from the annuity, those withdrawals are taxed as ordinary income.

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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