Do You Have to Take an RMD From a Non-Qualified Annuity?
Learn how non-qualified annuities avoid lifetime RMDs and understand the distinct tax and distribution rules that apply during life and for beneficiaries.
Annuities are contracts with insurance companies, and how they are taxed depends on their type. A non-qualified annuity is funded with after-tax dollars. Because of this, the Internal Revenue Service (IRS) does not impose the same Required Minimum Distribution (RMD) rules on non-qualified annuities during the owner’s lifetime as it does for retirement accounts like 401(k)s or traditional IRAs.
While you can let the funds in a non-qualified annuity grow without being forced to take withdrawals at a certain age, the contract is not free from distribution rules. Specific regulations govern how money can be taken out, how it is taxed, and what happens to the funds after the owner’s death.
Qualified vs. Non-Qualified Annuity Distribution Rules
The primary difference in distribution rules between qualified and non-qualified annuities stems from their funding source. Qualified annuities are purchased with pre-tax dollars inside of tax-advantaged retirement plans, such as a traditional IRA or an employer-sponsored 401(k). Because the contributions and earnings have not yet been taxed, the IRS mandates withdrawals to ensure it eventually receives tax revenue. These mandatory withdrawals are the familiar RMDs that must begin once the account holder reaches a specified age.
In contrast, because the principal in a non-qualified annuity was funded with after-tax dollars, the IRS does not compel distributions during the owner’s life. This allows the owner to let the contract’s value grow on a tax-deferred basis for a longer period without a forced withdrawal schedule.
Distribution and Taxation Rules for Non-Qualified Annuities
Although non-qualified annuities do not have lifetime RMDs, any withdrawals are subject to specific tax treatment. These distributions follow a Last-In, First-Out (LIFO) accounting method. This means that any earnings or gains in the contract are considered to be withdrawn first, and this portion is fully taxable as ordinary income. Only after all the gains have been distributed can the owner begin to withdraw their original principal, which is returned tax-free.
To illustrate, imagine an annuity purchased for $100,000 that has grown to a value of $130,000, resulting in $30,000 of earnings. If the owner decides to withdraw $40,000, the first $30,000 of that withdrawal would be considered a distribution of the earnings and would be fully taxable. The remaining $10,000 of the withdrawal would be treated as a tax-free return of a portion of the original principal.
Furthermore, there are age-related restrictions on accessing the earnings. If an owner withdraws from the earnings portion of the annuity before reaching age 59 ½, the taxable amount is subject to an additional 10% federal penalty tax. Certain exceptions can waive this penalty, such as the owner’s disability or taking distributions as a series of substantially equal periodic payments. These withdrawal rules are distinct from annuitization, where the owner receives guaranteed payments. With annuitization, each payment is split into a taxable gain and a non-taxable return of principal based on an exclusion ratio.
Distribution Rules After the Owner’s Death
The absence of required distributions for a non-qualified annuity ends when the owner dies. The options available to a beneficiary depend on whether they are a surviving spouse or a non-spousal beneficiary.
If the sole primary beneficiary is the owner’s surviving spouse, they have a unique option known as “spousal continuation.” This allows the spouse to step into the shoes of the original owner, treating the annuity as their own. The tax obligations are deferred until the surviving spouse takes withdrawals or passes away.
Non-spousal beneficiaries, such as children or other relatives, face more rigid requirements. The default distribution method is the “Five-Year Rule,” which mandates that the entire balance of the annuity must be distributed within five years of the original owner’s death. The beneficiary can take a lump sum or smaller withdrawals, as long as the account is fully depleted by the deadline.
Some annuity contracts offer a “stretch” provision as an alternative. If the contract permits this option, a non-spousal beneficiary can elect to receive payments based on their own life expectancy, starting within one year of the owner’s death. This can be a tax-efficient strategy, as it spreads the taxable income from the annuity’s gains over many years.