Qualified vs. Non-Qualified Annuities

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 of annuities 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

As with many annuity investments, 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. Some common sources of qualified annuity plans include:

• IRA accounts
• 401(k) plans
• 403(b) plans
• Simplified Employee Pension (SEP)
• Tax exempt savings plans

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 from a qualified annuity are mandatory at the age of 70½. However, annuity owners can begin withdrawing funds from this account at the age of 59½ without penalty. Funds withdrawn before that time will be subject to a 10 percent IRS penalty.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.

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 can postpone withdrawal until the age of 70½.

If the beneficiary is a non-spouse, annuity funds can be withdrawn in annual installments for a designated number of years. Taxes must be paid on all withdrawn assets.

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. Some common sources of funds for non-qualified annuities include:

• Mutual funds
• Non-IRA accounts
• Certificates of deposit
• Inheritance accounts
• Savings accounts

There is no limit to how much can be contributed to an annuity account, and there is no mandatory distribution age. Non-qualified annuity investments grow tax-deferred — an opportunity that allows the initial investment to accumulate interest without tax liability. As long as funds remain in this account, any income growth will not be taxed. However, as soon as the annuity begins disbursing to the annuity owner, any growth beyond the original investment will be taxed.

Similar to a qualified annuity account, early withdrawals from a non-qualified annuity before the age of 59½ are subject to a 10 percent IRS penalty.

Non-qualified annuities are unique because funds can be transferred from one policy to another without tax consequences. In a 1035 tax-free exchange, an annuitant can choose to invest in a new annuity, which in turn could help to increase income returns on an annuity account.

Death Benefit

Similar to many annuity accounts, non-qualified annuities can include a death benefit within the contract. In the event an annuity owner dies before receiving the full disbursement value, remaining funds can be transferred to a beneficiary or an heir. If no beneficiary or heir has been listed, funds may be forfeited to the insurance company.