What’s a Non-Qualified Annuity? & How They Work

Have you contributed the annual maximum allowed by the Internal Revenue Service to your IRA or 401(k)? Would you like to put some money away and have it grow without the IRS taxing you every year on the growth of the money you put into your account? If the answer to either of these questions is “yes,” you should take a look at non-qualified annuities. 

Jump ahead to these sections:

• The Definition of a Non-Qualified Annuity
• What’s the Difference Between a Qualified and Non-Qualified Annuity?
• How Does Taxation Work For a Non-Qualified Annuity? 
• How Does Distribution Work For a Non-Qualified Annuity?
• Alternatives to Non-Qualified Annuities

This article isn’t meant to talk you into buying an annuity; it’s intended to give you enough information to help you make an informed decision as you compare non-qualified annuities to other financial options you have.

Let’s look at what a non-qualified annuity is, how it compares to a qualified annuity, how taxes impact a non-qualified annuity, and how you get your money paid out when you’re ready for it. Finally, the alternatives section will give you ample food for thought as you consider your options.

The Definition of a Non-Qualified Annuity

Before we define a non-qualified annuity, let’s first explain what an annuity is. Here’s the definition in one sentence:

An annuity is a long-term investment that is issued by an insurance company and is designed to help protect you from the risk of outliving your income. (Nationwide)

Let’s break that down.

Long-term investment. An annuity isn’t like a savings account. They’re more like a 401(k) in that the money you put into an annuity is meant to be there for you as you age.

Issued by an insurance company. Insurance agents who represent insurance companies may sell either “fixed” or “variable annuities,” which is a topic of its own. The important thing is to know that a licensed insurance agent can help you buy an annuity.

From the risk of outliving your income. The most significant advantage of a non-qualified annuity is that you can’t outlive it like you can with an IRA or 401(k). Picture what it would be like to be a healthy 80-year-old who runs out of money in their retirement account and has to then rely only on Social Security. That can’t happen with an annuity designed to last a lifetime (more about that later).

A non-qualified annuity is like any other annuity, so it meets all of the points above. But it also has one additional feature: 

Funded with non-deductible contributions. You can’t deduct the money you put into a non-qualified annuity when you prepare your annual tax return like you can with a traditional IRA. 

What’s the Difference Between a Qualified and Non-Qualified Annuity?

So what’s the difference between “qualified” and “non-qualified” annuities?

The key difference is that qualified annuities are funded with tax-deductible contributions, while non-qualified annuities are funded with non-deductible contributions. 

A qualified annuity gets preferential tax treatment when you put money into it. That means you can deduct your contributions on your tax return for the year you made them. However, you’ll pay taxes on those contributions when you take money out of your annuity, in the form of income taxes.

A non-qualified annuity doesn’t get that same treatment. Instead, you pay income taxes on the full amount of your contributions for the year, since they’re not tax-deductible.

Other differences between the two include the cap on your annuity contributions and the requirements for distribution.

Here’s a graph that shows the differences between qualified and non-qualified annuities:

How Does Taxation Work For a Non-Qualified Annuity? 

As mentioned, a non-qualified annuity doesn’t qualify for preferential tax treatment when you put money into it. You pay taxes on your money before you contribute it to the annuity. In other words, the funds you put into your annuity do not qualify as a tax deduction.

The good news is that you don’t pay taxes on the money you contribute to your annuity (the principal) when you take money out, like you would have to with a qualified annuity withdrawal.  You already paid taxes on that money once.

However, when you take money out of a non-qualified annuity, you do have to pay taxes on any increase in the value of your initial contribution (the interest). The reason is that this increase is tax-deferred, meaning you don’t pay taxes on it as it grows. You pay taxes on it when it’s “realized,” or withdrawn. Every type of annuity features tax-deferred growth. 

So what makes an annuity so special when compared to IRAs and 401(k)s? It’s special because you can’t outlive it like you can outline other retirement investments. To be fair to IRAs and 401(k)s, those investments tend to earn higher rates of return than annuities.

How Does Distribution Work For a Non-Qualified Annuity?

As mentioned previously, you can’t outlive your annuity if you choose a lifetime payout option. But you do have other distribution options.

Lump-sum payout. If you’d like, you can take all of your money out of an annuity, whenever you’re ready, in one lump sum. Be aware, though, that if you take money out of your annuity before you turn 59½, you’ll pay a 10% early withdrawal penalty to the IRS, in addition to the taxes that will be due.

Payouts over a set term. You can also take your distribution over a period of time that you select when you purchase the annuity (generally 5, 10, 15, or 20 years). You might choose this option because you want to supplement other retirement earnings you have. If you die during this distribution period, the remaining payments will be made to a named beneficiary.

Lifetime payouts. The distribution of an annuity can also be structured to pay a lifetime income to the owner of the annuity, and when they die, the insurance company will continue the annuity payment until the end of a beneficiary’s life. Spouses generally purchase these annuities, which are called “joint and survivor life” annuities.

Regardless of which distribution option you decide to take, with a non-qualified annuity you’ll only pay taxes on the investment gain when you receive your payouts, not the principal you purchased the annuity with.

Alternatives to Non-Qualified Annuities

If you’re still not comfortable with the idea of buying an annuity, what other options do you have?

From a non-qualified standpoint, other investment vehicles include CDs, savings accounts, stocks or bonds, and mutual funds. 

If you choose to go this route, there’s a way to have an 80% probability that you won’t outlive your money if you take a set percentage every year.

For example, a 66-year-old with an annuity valued at $250,000 has an 80% probability of not outliving that annuity if they only withdraw 4% per year (adjusted for inflation annually).

The formula used to arrive at this probability is something called a “Monte Carlo” simulation. 

The Best of Both Worlds?

If you decide a non-qualified annuity isn’t right for you today, you might be looking for a different strategy. One option is to invest in something that pays a higher rate of return than an annuity. When you retire, you can take out that money and put it into an annuity.

This way, you can have your money grow at a faster rate while you’re younger, and when you retire, you’ll have the security of knowing you won’t outlive it. That’s a plan worth considering.