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- Updated: January 23, 2023
- 11 min read time
- This page features 10 Cited Research ArticlesKey Takeaways
- Qualified annuities are purchased with pre-taxed income. It only becomes taxable once you begin receiving the funds from your annuity. Owners of qualified annuities are required by law to begin taking distributions at the age of 72.
- Non-qualified annuities are purchased with after-tax dollars so only the earnings on your investment are taxable. There is no legal age requirement for withdrawing from a non-qualified annuity.
- Any money taken out before you turn 59 ½ will result in a 10% early withdrawal penalty in most cases.
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.
The key differences consist of whether the annuity is considered qualified or non-qualified. Qualified annuities are purchased with pre-tax dollars, while non-qualified annuities are funded with money that has already been taxed.
According to the IRS, a “qualified plan must satisfy the Internal Revenue Code in both form and operation.”Qualified Retirement Plans
- 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 72. 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 requirementSTEP 1STEP 2STEP 3
How soon are you retiring?STEP 1STEP 2STEP 3
What is your goal for purchasing an annuity?
Select all that apply
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STEP 1STEP 2STEP 3
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.Payout Options for Retirees
Peace of Mind Comes From Knowing Your Money Is ProtectedLearn more about how annuities can help provide you with guaranteed income, regardless of market conditions.
- 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.Pro TipAll money withdrawn from a qualified annuity is taxed as regular income. Conversely, only the earnings portion of withdrawals from non-qualified annuities is taxed.Source: Insured Retirement Institute
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% 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 72. 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:
Please seek the advice of a qualified professional before making financial decisions.Last Modified: January 23, 2023
- 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
Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.
- 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. (2022, June 15). Annuities – A Brief Description. Retrieved from https://www.irs.gov/retirement-plans/annuities-a-brief-description
- Internal Revenue Service. (2022, March 2). Publication 575 (2021), Pension and Annuity Income. Retrieved from https://www.irs.gov/publications/p575
- The Motley Fool. (n.d.). Taxation of Non-Qualified Annuities. Retrieved from https://www.fool.com/knowledge-center/taxation-of-non-qualified-annuities.aspx
- Investing Answers. (n.d.). Qualified Annuity. Retrieved from https://investinganswers.com/dictionary/q/qualified-annuity
- Mancini. J. (n.d.). What Is the Difference Between Qualified & Non-Qualified Annuities? Retrieved from https://budgeting.thenest.com/difference-between-qualified-nonqualified-annuities-25611.html
- Sahadi, J. (2018, May 11). Before choosing an annuity, know the tax implications. Retrieved from https://money.cnn.com/2018/05/11/pf/taxes/annuities-taxes/index.html
- Ciaran J. (2017, July 27). Qualified Vs Non-qualified Annuities. Retrieved from https://pocketsense.com/qualified-vs-nonqualified-annuities-7914354.html
- Insurance Information Institute. (n.d.) What are the different types of annuities? Retrieved from https://www.iii.org/article/what-are-different-types-annuities
- Suze Orman Financial Solutions For You. (2018). Annuities. Retrieved from http://apps.suzeorman.com/igsbase/igstemplate.cfm?SRC=MD012&SRCN=aoedetails&GnavID=84&SnavID=29&TnavID&AreasofExpertiseID=107
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