During retirement, annuities can be a great source of income, providing a way to schedule payments through a structured settlement. However, there is a difference between qualified and non-qualified annuities — if you have questions regarding the distinction between these two types, you’ve come to the right place.
What Are Annuities?
Purchasing an annuity is essentially buying an insurance contract through an insurance company. The purchaser pays the insurer according to the contract, and the insurance company makes periodic payments that can last for years, or even for life. It is also possible to defer payments until a later date, such as retirement.
It is possible to sell annuity contracts, partially or in full, for cash. Annuities can also be passed to loved ones as part of their inheritance. Some individuals will set up an annuity to ensure that their spouse will continue to receive payments when they pass away.
What Are Qualified Annuities?
Qualified annuities are funded by pre-tax dollars. It is typical to invest in a qualified annuity through a traditional IRA or employer’s retirement plan. Contributions to the qualified annuity will depend on your eligibility for other retirement plans, as well as your income. The minimum requirements for distribution that apply to IRAs and traditional 401(k)s are the same for qualified annuities, which means you can only start taking distributions at age 59.5.
Types of Qualified Annuities
A qualified annuity will often be set up by employers as part of their company’s retirement plan. The taxes associated with qualified annuities are only paid once distributions have been received, where some of the most common ways to start a qualified annuity plan include:
- 401(k) plans
- 403(b) plans
- IRA accounts
- Defined benefit plans
- Tax-exempt savings plans
- Simplified Employee Pension (SEP)
An annuity can be qualified once it meets certain IRS criteria while following regulatory guidelines. All contributions made to qualified annuity accounts will grow with their taxes deferred until it is disbursed, which is required to start taking distributions by the time the account holder reaches 70.5 years of age. However, owners of qualified annuity accounts can withdraw their funds starting at the age of 59.5 without incurring any penalties.
Funds withdrawn before this time will be subjected to a 10% penalty from the IRS. It’s important to remember that, because qualified annuities are purchased with pre-tax dollars, all withdrawals are taxable. Moreover, these earnings can also be moved to a similar account, without the need to worry about excess tax liability.
What are Non-Qualified Annuities?
A non-qualified annuity doesn’t involve your employer and is privately purchased. Payments are made with after-tax dollars, and you won’t have to worry about the required minimum distribution.
In these aspects, a non-qualified annuity is similar to a Roth retirement account. But unlike a Roth IRA, any earnings you withdraw from a non-qualified annuity will be taxable at a regular tax rate. While the IRS won’t limit how much you can contribute to your non-qualified annuity every year, the insurance company you purchase it from can place an annual cap on these contributions.
Types of Non-Qualified Annuities
Because the funds used to purchase the account are already taxed, the initial investment won’t be subjected to taxes once it’s disbursed. Here are some of the most common sources of funds for non-qualified annuities:
- Non-IRA accounts
- Non – Qualified accounts
- Inheritance accounts
- Certificates of deposit
- Savings accounts
There are a few benefits to choosing a non-qualified annuity, such as no limits to the mandatory distribution age, no limits to the amount you can contribute, as well as the opportunity to allow the initial investment to grow without being liable to tax. In other words, any income growth won’t be taxed as long as the funds stay in the account. But as soon as the annuity starts disbursing to the owner, any growth after the original investment is taxed.
Just like a qualified annuity account, those who make an early withdrawal before the age of 59.5 years from their non-qualified annuity account will be subject to a 10% penalty from the IRS. Another benefit to non-qualified annuities is that you can transfer funds from one policy to another without worrying about consequences from tax. By opting for a 1035 tax-free exchange, the owner of an annuity account can invest in a new annuity, where it may increase in income return.
The Similarities and Differences in Taxes Between Qualified and Non-Qualified Annuities
Both qualified and non-qualified annuities have a different set of rules when it comes to taxes at distribution. Below is a breakdown of what sets these options apart.
A qualified annuity will follow the tax rules stated on the plan you used to purchase it. For example, if you invested in a qualified annuity using your IRA or traditional 401(k), the IRS will tax it just like regular income when you withdraw it.
An account owner may face additional penalties if they don’t take their scheduled required minimum distributions (RMDs). Skipping your RMDs will result in a 50% penalty on your required withdrawal.
When it comes to non-qualified annuities, you’ll find that the only taxable part is the earnings from your initial investment. You will not have to pay taxes on the initial amount you used to buy the annuity because this is after-tax income.
Your qualified and non-qualified annuities may apply an early withdrawal penalty if you take money out of your account before you reach the age of 59.5. If you make an early withdrawal from your qualified annuity, the whole amount (your principal and earnings) could be considered as ordinary income tax. The earnings you get from making the withdrawal may also lead to a 10% penalty for early withdrawal.
The same thing could happen to your non-qualified annuity, where a 10% early withdrawal fee may apply. However, there are exceptions to this rule, such as:
- You needed to make an early withdrawal after becoming permanently disabled
- Your family needed to make an early withdrawal after your passing
Moreover, there is a workaround to avoid this penalty if you need to transfer money from a non-qualified annuity account to another.
Which Type of Annuity Should You Get?
The answer depends on your financial goals, retirement needs, and tax situation. To give you an idea, below is a breakdown of the benefits that a non-qualified annuity can provide:
- Only your earnings are counted as taxable income
- It has no annual contribution limit
- It has no required minimum distribution when you reach 70.5 years old
- Your earnings can be tax-deferred
If you want to contribute to your annuity indefinitely or you think that you’ll be in a higher tax bracket by the time you retire, a non-qualified annuity could be the best choice for you. If not, here are a few benefits that you can enjoy from a qualified annuity:
- Growing contributions
- Tax-deferred earnings
- Paying premiums using pre-tax dollars
If you think you’ll be in a lower tax bracket during retirement, it’s best to consider a qualified annuity since it will allow you to defer taxes on your earnings and contributions. Furthermore, getting a qualified annuity can provide advantages apart from guaranteed income, such as death benefits payable to other beneficiaries.
Choosing Your Annuity
If you’re set on incorporating an annuity into your financial plan for retirement, be sure to consider the following questions to help you make the right decision:
- When do you need your payments to start?
- Would you consider selling your annuity?
- How much can you invest in your annuity?
- What kind of tax treatment will work for you?
- How much money do you need the annuity to generate?
- Do you need it to pay benefits after you pass away?
Asking yourself these questions may help you choose between the options available to you.
How tax is treated is the main distinction between qualified and non-qualified annuities. As such, it’s important that you understand what these differences are. If you fail to do so, it may just be the reason why you run into all kinds of penalties that may cost more than you expect.
If you are thinking about getting an annuity, it’s essential to learn about contribution limits as well as RMD rules to ensure that you get all the benefits available to you. While one kind of annuity might be more beneficial than another when it comes to minimizing your taxes, it’s critical that you choose an option that works for you.
Speak to an annuity pro today to determine which option is best for you.