How Does a Non-Qualified Annuity Work?
Learn the essential mechanics of non-qualified annuities, including their growth phases and crucial tax considerations for your future.
Non-qualified annuities are a contract between an individual and an insurance company. Funded with after-tax money, contributions do not offer an immediate tax deduction. Their primary purpose is to allow funds to grow tax-deferred, converting into a stream of income, often for retirement planning. This financial product provides a reliable income stream over a specified period or for the annuitant’s lifetime.
Understanding Non-Qualified Annuities
Non-qualified annuities are purchased with after-tax money, unlike “qualified” annuities funded with pre-tax dollars through plans like 401(k)s or IRAs. This means contributions do not reduce taxable income. However, earnings grow tax-deferred, with taxes due only upon withdrawal.
The absence of contribution limits, unlike IRAs or 401(k)s, provides flexibility for individuals to save larger sums for retirement. Non-qualified annuities are also not subject to required minimum distributions (RMDs) at age 73, offering more control over when withdrawals begin. This flexibility makes them a suitable option for those who have maximized contributions to other tax-advantaged retirement accounts.
An annuity contract involves several parties:
The owner purchases the annuity and holds all contractual rights, including naming the annuitant and beneficiary.
The annuitant’s life expectancy determines the timing and amount of annuity payments; often, the owner and annuitant are the same.
The beneficiary receives any death benefits or remaining payments upon the annuitant’s death.
The insurance company issues and manages the annuity, guaranteeing payments according to the contract’s terms.
Non-qualified annuities come in various forms, such as fixed, variable, or indexed annuities. These classifications describe how funds grow and how returns are determined. For example, fixed annuities offer a set rate of return, while variable annuities’ performance depends on underlying investment options.
The Annuity Lifecycle
A non-qualified annuity typically progresses through two main phases: the accumulation phase and the payout, or annuitization, phase. These phases dictate how funds are managed and distributed over the life of the contract.
The accumulation phase is the initial period where funds are contributed to the annuity and grow tax-deferred. Contributions can be a single lump sum or a series of flexible premiums. The contract value increases through these contributions and tax-deferred growth.
During accumulation, the annuity may include surrender charges. These fees are imposed if funds are withdrawn or the contract is terminated prematurely, typically within the first five to seven years. Surrender charges are a contractual feature designed to discourage early withdrawals and allow the insurance company to recover its costs. Withdrawals or loans during this phase can incur these charges and may also be subject to tax implications.
The payout phase, also known as the annuitization phase, begins when the contract owner chooses to convert the accumulated value into a stream of regular income payments. This transition can occur at a predetermined date or when the owner decides to start receiving income. Annuitization involves selecting from various payout options, which determine the duration and amount of the payments. Common options include payments for a fixed period (period certain), payments for the life of the annuitant (life only), or payments for the lives of two individuals (joint and survivor).
The payout option directly influences payment duration and size. For instance, a life-only option provides higher payments but ceases upon the annuitant’s death. A period certain option guarantees payments for a specific number of years, even if the annuitant passes away sooner. Payments can be fixed or variable, fluctuating based on underlying investment performance.
Taxation of Non-Qualified Annuities
The taxation of non-qualified annuities is a significant aspect, primarily because contributions are made with after-tax dollars. This means that only the earnings within the annuity are subject to taxation upon withdrawal, not the original principal.
When withdrawals are made from a non-qualified annuity before annuitization, the Internal Revenue Service (IRS) applies the “Last-In, First-Out” (LIFO) rule. Withdrawals are considered to come from earnings first, which are then taxed as ordinary income. Only after all earnings have been withdrawn will subsequent amounts be a tax-free return of the original principal. Withdrawals made before age 59½ are subject to a 10% federal income tax penalty on the taxable earnings portion.
Upon annuitization, the “exclusion ratio” applies. This ratio determines the portion of each annuity payment that is a tax-free return of principal versus the taxable earnings. It is calculated by dividing the “investment in the contract” (total after-tax premiums paid) by the “expected return” from the annuity (total anticipated to be received over the payout period). For fixed annuities, this calculation is straightforward, while for variable annuities, it involves dividing the initial investment by the number of expected payments.
Once the exclusion ratio is established, a fixed percentage of each payment is considered a tax-free return of principal, while the remainder is taxed as ordinary income. For example, if the exclusion ratio is 20%, then 20% of each payment is tax-free, and 80% is taxable. Once the total amount of the original investment has been returned tax-free through this method, all subsequent annuity payments become fully taxable as ordinary income.
When a non-qualified annuity owner dies, tax treatment for beneficiaries depends on factors like their relationship to the deceased and the payout option. The earnings portion is taxed as ordinary income to the beneficiary. The principal, funded with after-tax dollars, is not taxed again.
Beneficiaries have options such as a lump-sum distribution, making the entire earnings portion immediately taxable, or receiving payments over a five-year period. A spouse beneficiary has the option to continue the annuity contract as the new owner, maintaining tax-deferred growth. Other beneficiaries may stretch payments over their life expectancy, allowing for continued tax deferral and potentially smaller annual tax liabilities.