What’s a non-qualified annuity?

Purchasing an annuity can give you guaranteed income in retirement, in addition to your other retirement incomes like pension, retirement plan distributions, and social security. However, before investing in an annuity, you should determine whether you want to purchase a qualified or non-qualified annuity.

A non-qualified annuity is an annuity that is purchased with after-tax dollars, meaning that you have paid taxes on the money you contributed to the annuity. When you take a distribution from the non-qualified annuity in retirement, you will only pay taxes on the earnings from investments. There are no IRS contribution limits on non-qualified annuities, but the annuity provider may set its own limits.

What is a non-qualified annuity?

A non-qualified annuity is a retirement product that is funded with after-tax dollars. The money grows tax-deferred, and you won’t pay taxes on the contributions until when you take a distribution. When you make a withdrawal from the annuity, you will only pay taxes on the earnings; the principal won’t be taxed since you already paid taxes on the money.

If you have other retirement accounts like IRAs and 401(k), you can max out your contributions to the accounts, and put more savings into a non-qualified annuity. There is no limit on the amount you can contribute to a non-qualified annuity, and you can make annual deposits to the account. However, if you want to take early withdrawals before retirement, you will pay a 10% penalty and income taxes on the withdrawal.

How does a non-qualified annuity work?

If you are looking to invest on a tax-deferred basis, non-qualified annuities may be a good option. You can invest in non-qualified annuities with after-tax money, which will grow tax-deferred until you make a withdrawal. Non-qualified annuities are not connected to any retirement accounts like 401(k) and IRAs, and this means you can deposit your contributions to the annuity once you have maxed out your retirement accounts.

Annuities have two phases i.e. an accumulation phase and a distribution phase. The accumulation phase is the phase where you contribute to the annuity, and your money grows tax-free depending on how it is invested. Usually, the insurer invests the money in subaccounts that are similar to mutual funds; how the annuity performs depends on the performance of the investments you chose. The distribution phase is when you receive distributions, either as automatic annuity payments or self-directed withdrawals.

If you annuitize your payments, the annuity agreement will determine what happens to any remaining payouts when you die. If you choose to receive annuity payments over a specified period, ensure that the payout option allows you to designate a beneficiary. If you choose to distribute annuity payments over your lifetime, the insurer will pay the annuity balance to your named beneficiaries or estate.

How non-qualified annuities are taxed

When you withdraw money from a non-qualified annuity in retirement, you will only pay income taxes on the earnings and interest; distributions of principal are not taxed. Income taxes are levied on a last-in-first-out basis, meaning that you will pay taxes on the withdrawal up to your investment earnings value.

For example, if you purchased a non-qualified annuity worth $200,000, and it is now worth $500,000, it means you have gained $300,000. Therefore, every amount you withdraw up to $300,000 will be subject to income taxes, since they are the last in.

Types of non-qualified annuities

Here are the main types of non-qualified annuities you can take:

Immediate and deferred

An immediate annuity allows you to make a one-time lump sum payment to purchase the annuity and start receiving payments almost immediately. On the other hand, a deferred annuity has an accumulation phase after you purchase the annuity when the money grows before you annuitize or make withdrawals.

Fixed, variable, and indexed

A fixed annuity pays a guaranteed interest rate on the annuity, and it is a good option if you are looking for a low-risk investment with stable returns.

You can also invest in a variable annuity, which invests in various securities like stocks, bonds, and mutual funds. Variable annuities have a higher earning potential, but they are subject to market risks that could result in negative returns.

If you want to invest in an annuity that is not subject to market-based risks, you can invest in a fixed-index annuity. This annuity benefits from upward growth based on market performance but without the downside risk of negative returns. However, some fixed-indexed annuities may cap the potential growth you can earn. 

Non-qualified annuities vs. qualified annuities

Both types of annuities impose early withdrawal penalties if you withdraw money before you are at least 59 ½. If you make a withdrawal before 59 ½, you will pay a 10% penalty on earnings. However, you may be exempted from the early withdrawal penalty if you are disabled or die. 

Non-qualified annuities and qualified annuities differ in several ways. The main difference is that non-qualified annuities are funded with after-tax dollars, meaning that you pay taxes on the contributions while qualified annuities are funded with pre-tax dollars, meaning you don’t pay taxes on contributions until when you withdraw funds from the annuity.

Additionally, there are no IRS limits on the amount you can contribute to a non-qualified annuity. You can contribute as much as you want, but some annuity providers may limit the amount you can contribute. In contrast, the IRS limits the amount you can contribute to a qualified annuity, depending on your income.

Non-qualified and qualified annuities have different tax rules for distributions. When you take a distribution from a non-qualified annuity, you will only pay income taxes on earnings; distributions of principal are not taxed. In contrast, you pay income taxes on both principal and earning distributions when you withdraw money from a qualified annuity.