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Non-Qualified Annuities (Everything You Need to Know)

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It’s no secret that in today’s marketplace, annuities are evolving. Most notably, there has been a massive shift from the traditional, qualified type of annuity to a more appealing, non-qualified variety. While this evolution is certainly integral to the current state of annuities, many investors are still wary to jump on board this trend.

If you’re considering a non-qualified annuity, you have come to the right place. We’ll discuss everything you need to know about this investment plan and how it can assist you in growing your retirement portfolio. With better knowledge, you’ll be more confident that you’re on the right track to your financial goals.

What Is an Annuity?

Before we explore the definition of a non-qualified annuity, let’s first understand what an annuity is. In its simplest form, think of an annuity as a financial contract you can use to create long-term payments for yourself and your loved ones. With an annuity, you can receive monthly payments for a specified period or lifetime. This type of investment is ideal for individuals who want to ensure their savings will last the rest of their life.

Annuities are investment vehicles that help you generate cash flow in the future. For tax purposes,   there are two basic types: qualified and non-qualified. Non-qualified annuities (NQAs)  are purchased with after-tax funds, meaning you’ve already paid taxes on the funds used.  Qualified annuities are purchased from pre-tax funds, meaning you haven’t paid taxes on the funds yet.  Examples of Qualified accounts are your IRA or 401(k).

When buying an annuity, you deposit money with the insurance company with the promise that the insurance company will send you payments in retirement. In an annuity, you can make either one or multiple payments to your insurance company, known as premiums.

However, take note, that not every annuity guarantees lifetime income. As with any insurance product, you should work with an experienced agent to educate yourself  in order to make an informed decision when purchasing an annuity.

Non-Qualified Annuity — Explained

A non-qualified annuity (also referred to as an after-tax retirement annuity) is a long-term retirement savings product that allows you to earn interest with after-tax dollars. Since you contributed after-tax dollars, the taxes are deferred until withdrawal. Beyond that point, any distributions will be taxed only on gains, leaving the rest of your original principal untouched.

While commonly used in a retirement plan, non-qualified annuities can be utilized outside those applications in certain situations. In some instances, they provide the benefit of letting your money grow tax-deferred and include certain tax deferments that may lower your overall taxable income. 

Moreover, a non-qualified annuity can be used as an income source within retirement to increase the level of income you receive. The cash it provides is an excellent supplement from other assets or cash flow you may have, such as social security or a company pension.

(there are also qualified annuities – learn the difference)

Notable Features of a Non-Qualified Annuity

To better understand this type of annuity, here’s a summary of its features:

  • Income tax is withheld on the earnings from a nonqualified annuity. The Internal Revenue Service IRS doesn’t tax the principal or the premium payments.
  • This annuity isn’t linked to an employer-sponsored retirement plan, such as a 401(k) or IRA. You can purchase it through various types of investments, including mutual funds or index funds or fixed rates. .
  • Non-qualified annuities are paid out of your general pool of assets, which means you usually don’t need to be actively working or have earned income. Compared to the qualified annuity, you can still qualify for and purchase it without active work.
  • The IRS doesn’t set Required Minimum Distributions (RMDs) on non-qualified annuities, although a provider can restrict your premiums. The IRS sets a cap on what you can contribute annually to a qualified annuity.
  • Withdrawals before age 59 ½ from a non-qualified annuity will result in less of a tax hit than withdrawals from a qualified annuity.

Non-Qualified Annuity: How Is It Taxed?

All annuities are granted tax deferral, which means the interest or profits from the investment or interest earnings aren’t taxed as long as it is kept in that account. However, there are different ways in which taxes are taken out for non-qualified annuities. When received, income from your non-qualified annuity is taxed using either the Last-In-First-Out (LIFO) or the Exclusion Ratio.

If you have taxable interest and earnings, LIFO ensures that any gains are prioritized for tax deductibility. Once all your capital gains are used, there will be no taxes due from the annuity. Meanwhile, the Exclusion Ratio is the percentage of an annuity payment that’s excluded from gross income, which means it’s not subject to ordinary income tax. You can calculate it by dividing the premium by the expected return.

Taxes for Withdrawals

Generally, you aren’t taxed on the withdrawal of the principal. In the case of lifetime withdrawals or penalty-free withdrawals, taxes will be applied only if there are earnings and interest. The government utilizes the LIFO protocol of the IRS if you’re filing a non-qualified annuity distribution. In addition, both traditional withdrawals and lifetime income use the LIFO method.

Annuitization

A non-qualified annuity is one of the most popular ways to invest on a tax-deferred basis for people looking for additional ways to save and grow their nest egg. It can also provide regular income during retirement if you prefer to annuitize. 

The IRS uses a calculation called the exclusion ratio to determine how much of an annuitized withdrawal from an annuity is taxable. This calculation is based solely upon deposited principal, and earned interest.

Non-qualified Annuities & the Internal Revenue Code 1035 

At some point, you may want to switch your annuity if you think another product can better meet your financial goals. That said, how do you complete an exchange without paying taxes on the gains? You can take advantage of the Internal Revenue Code (IRC) 1035. This part of the IRS code allows you to exchange or swap a recent annuity purchase for one with lower fees or a higher rate of return, for example, to postpone taxes on your investments.

Do note that in the 1035 exchange process, the owner, annuitant needs to be the same. Also, the tax qualifications must stay the same. For example, Non-Qualified must be exchanged for another Non-Qualified product. The annuity contract can be amended after a 1035 exchange is complete. In addition, you must use the 1035 exchange form. In most cases, we don’t recommend cashing out your old annuity and purchasing a new one, as this would qualify as taxable income with the IRS.

Secure Your Future With Safe Wealth Plan

In the end, non-qualified annuities can be a powerful tool to help you achieve financial security in retirement. The trick is to understand how they work and which products are best for you. Don’t rush your decision; work with an experienced agent and take the time to review all the potential income options and evaluate which one is right for you.

There are many reasons why you may be considering a non-qualified annuity. If you’re stuck on which type of annuity contract is best for your situation, you can always seek professional advice at Safe Wealth Plan. Our experienced licensed agents can assist you in finding the right annuity for your specific needs.

Download our FREE guide to understanding annuities

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About the Author: Benjamin Hulburt

Benjamin Hulburt - Safe Wealth Plan
 

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