Qualified vs. Non-Qualified Annuities
All annuities fall into one of two categories — qualified and non-qualified — which differ in how the funds are taxed.
The Difference Between Qualified and Non-Qualified Annuities
Annuities are long-term investment vehicles used to protect financial assets and secure financial futures. While they come in many forms including fixed, variable, deferred and immediate, annuities fall into one of two main classifications: qualified and non-qualified.
These two categories determine how contributions or withdrawals from the accounts are taxed. A qualified annuity is bought with pre-tax dollars that usually come from an IRA account, 401(k) or some other retirement fund. Non-qualified annuities are an outside investment bought with after-tax dollars and are typically not used to fund a retirement plan.
Qualified Annuities
A qualified annuity is a financial tool used to help accumulate funds for retirement. Bought with pre-tax dollars, this type of annuity is usually set up through an employer and taxes are paid only when distributions are received.
All contributions made to a qualified annuity account grow tax-deferred until disbursed, typically at the age of 70½. Unlike a non-qualified account, disbursements are mandatory at age 70½. However, owners can begin withdrawing funds at age 59½ without penalty.
Because a qualified annuity was purchased with pre-tax dollars, all withdrawals are taxable. Qualified annuity earnings can also be rolled over into a similar account without causing any excess tax liability.
Common Sources of Qualified Annuities:
- IRA accounts
- 401(k) plans
- 403(b) plans
- Simplified Employee Pension (SEP)
- Tax exempt savings plans
Death Benefit
In the event an annuity owner dies before receiving all of their assets, qualified annuity funds can be transferred to a surviving spouse or death beneficiary. A spouse can roll over the annuity into a similar IRA account and postpone withdrawal until age 70½.
Common Sources of Non-Qualified Annuities:
- Mutual funds
- Non-IRA accounts
- Certificates of deposit
- Inheritance accounts
- Savings accounts
Death Benefit
Non-qualified annuities can include a death benefit within the contract. In the event an owner dies before receiving the full disbursement value, remaining funds can be transferred to a beneficiary or heir. If no beneficiary has been listed, funds may be forfeited to the insurance company.
Non-Qualified Annuities
A non-qualified annuity is a privately purchased annuity bought outside of an employee benefit. The funds used to buy this account have already been taxed, so the initial investment is not subject to taxes once disbursed.
There is no limit to how much can be contributed to a non-qualified annuity account, and there is no mandatory distribution age. Investments grow tax-deferred — allowing the initial investment to accumulate interest without tax liability.
Non-qualified annuities are unique because funds can be transferred from one policy to another without tax consequences through a 1035 tax-free exchange. This allows annuitants to invest in a new annuity, which could help increase income returns.
Side-by-Side Comparison
Understanding the key differences between qualified and non-qualified annuities.
Qualified
Non-Qualified
Key Points to Remember
Tax Treatment
Qualified annuities are fully taxable on withdrawal; non-qualified only tax the growth portion.
Distribution Rules
Qualified annuities require mandatory distributions at 70½; non-qualified have no such requirement.
Early Withdrawal
Both types incur a 10% IRS penalty for withdrawals before age 59½.
Death Benefits
Both types allow funds to be transferred to beneficiaries with proper planning.
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