Annuities are one of the most popular financial products people purchase to plan retirement. However, annuities can be qualified or non-qualified, and there is a big difference between the two. Both are long-term, tax-deferred investments for retirement. This guide will help you understand what qualifies an annuity as qualified or non-qualified to make the right choice for your future!
Qualified Annuities vs. Non-Qualified Annuities
A qualified retirement plan is a type of retirement plan that meets specific requirements set forth by the IRS. Qualified retirement plans include 401k, 403b, and most pension plans. The main benefit of a qualified retirement plan is that the contributions are tax-deferred. This tax advantage means you will not pay taxes on the money you contribute to the plan until you withdraw it. Qualified retirement plans also have lower fees than non-qualified retirement plans.
A non-qualified retirement plan is a type of retirement plan that does not meet the requirements set forth by the IRS. Non-qualified retirement plans include annuities and life insurance policies. The main benefit of a non-qualified retirement plan is that the contributions are not tax-deferred. This benefit means that you will pay taxes on the money you contribute to the plan when you contribute. However, non-qualified plans may also have higher fees than qualified retirement plans.
Tax-Deferral
Except for immediate annuities, all annuities are tax-deferred. This implies that any income the investment generates is not taxed until it is paid to the annuity holder. There are, however, distinctions between whether and when taxes must be paid on the annuity principal (the money used to buy or fund the annuity).
The distinction between qualified and non-qualified annuities is based on how the annuity is funded. Qualified annuities are funded with pre-tax money, whereas non-qualified annuities are funded with post-tax dollars.
Qualified retirement plans include:
- Individual Retirement Arrangements (IRAs)
- Roth IRAs
- 401k Plans
- SIMPLE 401k Plans
- 403b Plans
- SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
- SEP Plans (Simplified Employee Pension)
- SARSEP Plans (Salary Reduction Simplified Employee Pension)
- Payroll Deduction IRAs
- Profit-Sharing Plans
- Defined Benefit Plans
- Money Purchase Plans
- Employee Stock Ownership Plans (ESOPs)
- Governmental Plans
- 457 Plans
This has implications for annuity payments and withdrawals. The taxation of annuities is also affected by this. In addition, these categories of annuities are treated differently in several other ways under the law.
Contributions Limits
Unlike non-qualified annuities, qualified plans limit how much money may be invested in them. These limitations are determined by the annuity holder’s income and participation in other qualified pension plans. Think of a qualified annuity as a 401k or IRA because they all have annual contribution limits.
Qualified vs. Non-Qualified Annuity Taxes On Withdrawals
All money withdrawn from an annuity (qualified and non-qualified) is taxed as ordinary income (Roth IRA is not taxed). All withdrawals in a qualified annuity are taxed as regular income. Only the interest earned from non-qualified annuities is taxed.
Non-qualified annuities are taxed by the IRS in different ways depending on how the income is received. For example, suppose a withdrawal is made or lifetime withdrawals from an income rider are distributed to the annuity owner. In that case, the income will be taxed, Last In, First Out (LIFO), which means the interest will be withdrawn before your investment. If an income is distributed via an annuitization, annuity payments are taxed proportionately (your investment/interest earned) through an exclusion ratio method.
| Qualified Annuity | Roth Annuity | Non-Qualified Annuity | |
|---|---|---|---|
| Funded With | Pre-taxed Money | After-Tax Money | After-Tax Money |
| Withdrawals | 100% Taxable | Tax-Free | Interest-Only Taxed (LIFO) |
| Annuitized Payments | 100% Taxable | Tax-Free | Exclusion Ratio |
| RMDs | Yes, at Age 73 | No | No |
| Contribution Limit | Yes | Yes | No |
Distributions Age Limits
You must be 59 and a half years old before withdrawing funds from either a qualified or non-qualified annuity. If you take the money out before that, you’ll have to pay a 10% tax penalty on any gains. Annuity holders who become disabled or pass away are exempt.
Owners can withdraw from their annuity earlier than 59 ½ without a penalty via 72(t) distribution for qualified annuities and 72(q) distribution for non-qualified annuities.
Under the Internal Revenue Code, owners must take qualified annuity payments (RMD) at 73. However, there are no federal legal guidelines for withdrawing from non-qualified annuities.
Transfers and 1035 Exchanges
1035 exchanges allow non-qualified annuity owners to transfer funds from one deferred annuity to another without incurring a tax penalty because the exchanges are covered by Section 1035 of the Internal Revenue Code.
Qualified annuities allow for such transfers, but only funds inside the annuity that have been tax-deferred are allowed. So, for example, a 401k can be transferred to an IRA annuity because both are qualified retirement plans. This is called a 401k Rollover. Another example is the transfer of a traditional IRA to an IRA annuity, called a Direct Transfer.
Request A Quote
So, which type of retirement plan is right for you? Request a quote from one of our retirement specialists today to find out. We will help you compare the different plans and find the best option. So, contact us today to get started! This service is free of charge.