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A qualified annuity is purchased with pre-tax dollars, such as funds from an IRA or a 401(k). Qualified annuity premiums may be tax deductible. A non-qualified annuity is purchased with after-tax dollars that were not from a tax-favored retirement plan. Non-qualified annuity premiums are not deductible from gross income.
All annuities are allowed to grow tax-deferred. This means any earnings on the investment are not taxed until they are paid out to the annuity holder. However, there are differences that govern if and when taxes are due on the annuity principal, the money used to purchase or fund the annuity.
These differences come down to whether the annuity is considered qualified or non-qualified. Qualified annuities are purchased with pre-tax funds, while non-qualified annuities are funded with money on which taxes have been paid.
According to the IRS, a “qualified plan must satisfy the Internal Revenue Code in both form and operation.”
- 401(k) plans
- 403(b) plans
- SARSEP plans
- SEP-IRA plans
- SIMPLE IRA plans
This affects the taxes on withdrawals or payouts from the annuity. The law also treats these classes of annuities differently in other respects.
|Type||Purchased With||Annual Cap on Purchase||Withdrawal Funds Taxed||Distribution Requirement|
|Qualified||Pre-tax funds (Tax-favored retirement money, such as IRA contributions)||Yes. The IRS limits how much of your income you may invest annually||Yes. Payouts are taxed as income.||You must begin withdrawing funds by age 70 1/2.|
|Non-qualified||After-tax funds (Money on which taxes have been paid)||No cap||Only your earnings are taxed as income; principal is not.||No requirement|
Taxes Are Deferred
Qualified annuities are purchased with pre-tax dollars, such as money from an IRA. The IRS says the premiums from a qualified annuity may be wholly or partially tax deductible. Any applicable tax payments on this type of annuity are deferred until the money is withdrawn.
In other words, buying a qualified annuity is like contributing to a 401(k). The money you use to purchase a qualified annuity is subtracted from your annual income in the year you make the purchase. It is taxed only when you begin to receive the funds from the annuity, usually in retirement.
With a non-qualified annuity, your purchase is made with money on which you have paid income or other applicable taxes already. Its purchase is not connected to a tax-favored retirement plan.
Qualified Annuities and Retirement Plans
Qualified annuities are treated like tax-favored retirement plans. In fact, they are often purchased through an employer tax-favored retirement plan. They’re also purchased with money from an IRA, 401(k), or another account that is tax deferred.
Unlike non-qualified annuities, qualified annuities have caps on how much money may be invested in them. These caps are governed by the annuity holder’s income and whether he or she participates in other qualified pension plans.
Retirees may choose to take their annuity income benefits in one of several payout structures.
- A lump sum payout
- An annuitized income stream for life
- An annuitized income stream for a specific time period
Qualified vs. Non-Qualified Annuity Withdrawal and Taxes
When funds from a qualified annuity — one purchased with pre-tax dollars from a traditional IRA or other retirement account — are distributed to an annuity holder, the entire amount is taxable because taxes have never been paid on those funds.
When money from a non-qualified annuity is withdrawn, on the other hand, there are no taxes due on the principal. Income taxes are levied only on the earnings and interest. If you purchased your non-qualified annuity after August 13, 1982, your distributions will follow the “last-in-first-out” protocol of the IRS.
The IRS determines which portion of a non-qualified annuity withdrawal are taxable by using a calculation known as the exclusion ratio. This ratio 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 for their entire life, the exclusion ratio will take their life expectancy into consideration. The idea is to spread the principal and earnings over the owner’s lifetime. If they live longer than their calculated life expectancy, all payments beyond that time period are taxed as income.
So, for example, if your calculated life expectancy is 85 years old, then the exclusion ratio will determine how much of each payment from your non-qualified annuity will be considered taxable earnings until you turn 85. After the age of 85, all payouts from the annuity are considered taxable income.
If your annuity was purchased with funds from a Roth IRA or Roth 401(k) — as opposed to money from a traditional IRA or 401(k) account — the withdrawals are tax-free.
Distribution and Transfers
Both qualified and non-qualified annuities require you to be 59 ½ before withdrawing funds. If you withdraw the money before that, the IRS imposes a 10-percent tax penalty on earnings. There are exceptions for annuity holders who become disabled or die.
Federal law requires the owners to begin taking distributions from qualified annuities at the age of 70 ½. There are no federal legal requirements for when withdrawal must begin from non-qualified annuities. Some state laws may set requirements, however. These may be in the annuity contract you have with the annuity provider.
With non-qualified annuities, you can transfer the funds between different kinds of annuities, such as fixed and variable, without facing an early-withdrawal penalty because the exchanges are covered by Section 1035 of the Internal Revenue Code. These transfers are known as 1035 exchanges.
With qualified annuities, such transfers can take place, but the transfers are limited to funds in the annuity that are considered tax-deferred.
Possible reasons for such transfers could be:
- A fixed annuity owner might want an annuity with a higher interest rate.
- The annuity company may not be financially strong.
- A new annuity contract may be more appealing, offering desirable features such as an enhanced death benefit or guaranteed minimum income. Or the new contract may have better investment options.
- The new contract may have lower fees.
10 Cited Research Articles
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- Internal Revenue Service. (2021, February 11). A Guide to Common Qualified Plan Requirements. Retrieved from https://www.irs.gov/retirement-plans/a-guide-to-common-qualified-plan-requirements#return
- Internal Revenue Service. (2018, July 30). Annuities – A Brief Description. Retrieved from https://www.irs.gov/retirement-plans/annuities-a-brief-description
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