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qualified vs nonqualified annuities

Qualified vs Nonqualified Annuities, What’s the Difference?

Categories: Annuity Education, General Interest

Even if you’re lucky enough to love your work, the fact is, you’re going to have to retire eventually. This is a major life event on par with getting married or having children, and it’s similarly something that you need to carefully plan for.

Annuities are just one of many ways of doing this, and there are many complexities and subtleties to annuities. Today, we’re going to walk through the differences between two of the major types of annuities, qualified and nonqualified annuities, to help you understand which you should consider for your retirement.

What is An Annuity and How Does it Work?

Annuities are contracts set up between you (the annuitant) and an insurance company. They come in many forms, including the “qualified” and “nonqualified” varieties we’ll discuss below, but the basic idea is pretty straightforward.

In essence, you’ll “fund” the annuity by either paying a single lump sum all at once, or making a series of payments over time. Once that’s done the annuity either grows in value tax-deferred, or begins paying you an income. It’s possible to start getting these payments immediately, but it’s also common to initiate them at some pre-determined point in the future, such as when you retire.

It can sometimes help to contrast an annuity with life insurance. Where the purpose of life insurance is to pay out after you’re gone, protecting those you leave behind, the purpose of an annuity is to pay you a steady stream of guaranteed income while you’re still alive.

What is a Qualified Annuity?

One of the two major types of annuities is known as a “qualified” annuity. “Qualified” just means that when you funded the annuity as described above, you did it with dollars that were part of a tax qualified retirement plan and, with the exception of ROTH accounts, have not yet been taxed.

While that money is in the qualified annuity it grows without you needing to pay income taxes on the interest earnings or gains; once withdrawals or income distributions begin, however, you’ll be taxed on the full amount received (excluding ROTH).

You can find more information on the tax implications of annuities if you’re interested.

What are the Different Funding Sources for Qualified Annuities?

Qualified annuities are typically funded with existing tax qualified retirement accounts, such as 401(k)s and 403(b)s, but most commonly IRAs. 

401(k)s are created by for-profit companies, giving employees the opportunity to defer a portion of their pre-tax wages, and in many cases include some type of employer matching. Currently, annuity options available directly within 401(k) plans are somewhat limited, but with the passage of the 2019 SECURE Act, it is possible that more companies will begin adding annuity options to their 401(k)s.

Even if annuity options are not directly available within your employer’s 401(k) plan, upon separation from service with your employer, you will have the opportunity to rollover your 401(k) into your own IRA, which could then be used to purchase a qualified annuity.

A 403(b) is similar to a 401(k), but targeted at a different audience. 403(b)s are offered through organizations that are tax-exempt, and used to fund retirements for teachers, public servants, and similar kinds of employees.

An Individual Retirement Account (IRA) is another retirement-savings vehicle through which you can get a qualified annuity. There are different types of IRAs, including Traditional and ROTH IRAs. You can fund a qualified annuity with an existing IRA, or you can use new contributions. If you use new contributions, you’ll have an IRS imposed annual contribution limit of $7000, which increases to $8000 if you’re over 50 (for 2024).

Note, however, that IRA Transfers and Rollovers from previously established accounts don’t count toward this annual limit.

What is a Nonqualified Annuity?

Now, we’ll turn to discussing the other major kind of annuity, a nonqualified annuity.

Unlike qualified annuities, nonqualified annuities are funded with post-tax dollars, meaning dollars on which you’ve already paid all your taxes. Like a qualified annuity, the money you put into a nonqualified annuity will grow tax-deferred until withdrawn. The big difference comes later, when distributions start. Your nonqualified annuity will be taxed differently than a qualified annuity, you’ll only be taxed on the accumulated gains and not on your original deposit premium (cost basis).

This has several implications, which we’ll discuss in the section below on the differences between qualified and nonqualified annuities.

What are the Different Funding Sources for Nonqualified Annuities?

There are a few different ways of funding a nonqualified annuity, with some of the most common being from existing mutual funds, savings accounts, and bank-issued certificates of deposit (CDs).

The first mutual fund was the Massachusetts Investors Trust established in 1924, and ever since they’ve been a popular way of investing. Mutual funds are established by investment companies, which then pool their investor funds to buy a portfolio of financial assets, including stocks and bonds.

A savings account is exactly what it sounds like – an account you open with an institution like a bank for the purpose of saving money long-term.

Certificates of deposit (CDs) are very similar to multi-year guarantee annuities (MYGAs), only they’re issued by a bank instead of an insurance company.

Using existing money from mutual funds, savings accounts, and certificates of deposit are all ways you can get a nonqualified annuity.

What is the Difference Between a Qualified and Nonqualified Annuity?

There are many differences between a qualified and nonqualified annuity, mostly stemming from the ways in which they’re funded and taxed. It is to these differences that we now turn.

Qualified annuities are funded with pre-tax dollars, while nonqualified annuities are funded with post-tax dollars. Moreover, the IRS imposes no annual contribution limits on a nonqualified annuity, whereas qualified annuities are capped at $7000 per year or $8000 if you’re over 50 (for 2024).

Similarly, nonqualified annuities have no required minimum distributions. The owner of a qualified annuity has to start taking money out of it by the time they reach 73, but the owner of a nonqualified annuity can hold their funds in a tax-deferred status indefinitely.

If you choose to take your funds out of a nonqualified annuity before age 59 1/2, you can expect less of a tax penalty. Early withdrawals from either type of annuity are subject to a 10% IRS penalty, but that amount applies to all the funds withdrawn from a qualified annuity, whereas it only applies to earnings and interest withdrawn in the case of a nonqualified annuity.

Should You Buy a Qualified or Nonqualified Annuity?

There are many things to consider when you ask yourself this question, including; what are your income needs, what is your tax situation, how close to retirement are you, and more.

For this reason, it will likely make sense for you to consult an annuity professional as you navigate this terrain, and we at AnnuityAdvantage specialize in helping people like you make the best decision possible. Reach out today to talk with one of our Annuity Specialists.