What Is a Non-Qualified Annuity?
Are you concerned about outliving your retirement savings? Most people have a goal of living a long, happy life — and that includes having enough money to fund their basic needs and even some fun extras into their seventies, eighties and beyond. An annuity can help ensure you have enough money to live, regardless of your lifespan or needs as you age.
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What Is a Non-Qualified Annuity?
A non-qualified annuity is an investment issued by insurance companies that pays out benefits immediately or in the future. A non-qualified annuity is paid for with after-tax dollars, which means you won’t pay taxes on most of the benefits you receive. You will pay taxes on any interest and earnings but not the principal.
What’s the Difference Between Qualified and Non-Qualified Annuity?
A qualified annuity is paid for with pre-tax dollars. That means you’ll pay taxes when you receive withdrawals from your qualified annuity. On the other hand, only interest and earnings are taxed with a non-qualified annuity.
Since they are tax-deferred accounts, qualified annuities also have annual contribution limits set by the IRS. In 2024, the limit for a longevity annuity contract is $200,000. To pay into a qualified annuity, you must have earned income, which is not the case with a non-qualified annuity. A qualified annuity is more like a 401(k), where you pay with pre-tax dollars.
Additionally, you don’t have to take required minimum distributions with a non-qualified annuity. You can decide when you want to start withdrawing funds. With a qualified annuity, you must start taking RMDs by age 72, regardless of your financial situation.
Since qualified annuities are a tax-deferred investment, you could wind up with additional tax liabilities for withdrawals. It’s important to speak with a tax advisor before withdrawing funds from a qualified annuity, as there may be legal methods of tax avoidance they can share that will help you continue receiving the full income you need in your later years.
Finally, early withdrawals prior to age 59 ½ from a qualified annuity face a 10% tax penalty on the full withdrawal. Non-qualified annuities will only see that penalty on earnings and interest. However, interest and earnings will be distributed before the principal, so you will still pay taxes on early withdrawals at first. Keep in mind that interest from a non-qualified annuity is taxed at your federal marginal income tax rate, not as long-term capital gains.
Some non-qualified annuities may also have withdrawal penalties or surrender charges if you access the funds before a specific date. They may also have high administrative fees or investment management fees.
Roth IRA Annuities: Convert Your Savings Into a Retirement Fund
There are many ways to save for retirement, including IRAs, Roth IRAs, annuities and 401K accounts. It’s important to recognize several distinctions:
An annuity is not life insurance, even if you buy it from an insurance company
An annuity is not a Roth IRA or other retirement savings account
Your Roth IRA can own an annuity
If you have most of your savings in a Roth IRA, which is also paid with after-tax dollars, you can use it to purchase an annuity. You gain the benefits of a guaranteed income for life, without paying taxes on principal withdrawals in retirement.
If you feel that your retirement income might be higher than what you are earning now, whether due to an inheritance, royalties on work you created in your earlier years or investments, this could be the right choice to reduce taxes in retirement.
Some 401k products will also permit you to purchase an annuity with your savings.
Annuity vs. Other Retirement Savings Options
Many people have multiple investments to help fund their retirement, such as a 401(k), IRA, pension and even money in the stock market, mutual funds, ETFs, CDs or savings. Most people planning for retirement want to keep the bulk of their savings in low-risk accounts, which means you aren’t likely to lose your principal investment regardless of market conditions.
However, the lower the risk profile, the smaller the reward. Low-risk investments may not have high earnings. But as long as your earnings can keep pace with inflation, the power of compounding, where your interest is re-invested to earn even more, will help your retirement nest egg grow over time. On the plus side, an annuity can help set you up with income for life.
For a low-risk investment, fixed annuities typically offer a higher yield than savings accounts, money markets or CDs, offering the ideal blend of low risk and relatively high returns compared to many other savings vehicles.
Pros and Cons of Non-Qualified Annuities
Here are some of the advantages and drawbacks of non-qualified annuities.
Pros
No contribution limits
Withdrawals from principal aren’t taxed
No earned income required to purchase
No required minimum distributions
Financial security and guaranteed income
Cons
No tax advantage during your working years
High fees
Withdrawal or surrender penalties
Lower returns than some other investments
Types of Non-Qualified Annuities
Depending on your risk tolerance, you can choose from three different types of annuities. Always be sure to ask a financial advisor about associated fees and costs to find the best product for you.
Fixed Annuity
A fixed annuity promises a specific rate of return and doesn’t fluctuate based on the stock market or the federal funds target interest rate. At times, the company holding the annuity may offer a higher interest rate for a limited time, but the rate will not drop below the fixed rate.
Variable Annuity
A variable annuity, as the name implies, delivers returns based on the performance of the stocks that make up the annuity.
Fixed Indexed Annuity
A fixed indexed annuity delivers the best of both worlds. This investment is tied to the stock market, typically an index like the Nasdaq or S&P 500, but comes with a guarantee that the interest won’t drop below a set minimum, even if the stock index underperforms.
Key Takeaways
A non-qualified annuity provides a relatively low-risk retirement investment, delivering income for the length of your retirement. Since you pay with after-tax dollars, only your interest or earnings are taxed upon withdrawal.
FAQ
Here are the answers to some of the most frequently asked questions about non-qualified annuities.
Do I have to pay taxes on a non-qualified annuity?
Since you have already paid taxes on the money deposited into a non-qualified annuity, you can withdraw the principal tax-free. Interest and earnings, however, are taxed at the federal marginal income tax rate, not as long-term capital gains.
What is the 5-year rule for non-qualified annuities?
An annuity can help preserve generational wealth since you can pass an annuity onto a non-spouse heir. However, the beneficiary must withdraw the entire balance within five years of inheriting the annuity. They can withdraw all the money immediately, take distributions over the course of five years, or withdraw all funds at the end of five years, according to the five-year rule.
Can you withdraw money from a non-qualified annuity?
You can withdraw money from a non-qualified annuity at any time. With a deferred annuity, you may have to wait a specified amount of time, otherwise you could pay fees and additional taxes on the interest withdrawn. A non-deferred annuity lets you start taking distributions immediately.
This article originally appeared on GOBankingRates.com: What Is a Non-Qualified Annuity?
