What Does a Non-Qualified Annuity Mean?

Annuities are contracts with an insurance company, structured to provide a steady income stream, often utilized for retirement planning. A non-qualified annuity is purchased with after-tax dollars, meaning contributions do not offer an upfront tax deduction. The “non-qualified” label refers to this tax treatment, indicating funds have already been taxed, distinguishing it from qualified plans where contributions are typically pre-tax.

Understanding Non-Qualified Annuity Structure

Once these funds are contributed, the money within the annuity enters an “accumulation phase” where it grows on a tax-deferred basis. This tax deferral means that any earnings, such as interest or investment gains, are not taxed until they are withdrawn.

Several parties are involved in an annuity contract: the owner, the annuitant, and the beneficiary. The owner is the individual or entity who purchases the annuity and controls the contract, including the right to make withdrawals or designate beneficiaries. The annuitant is the person whose life is used to determine the duration of annuity payments. The beneficiary is the person or entity designated to receive any remaining funds or death benefits upon the owner’s death. Premiums can be contributed to the insurance company either as a single lump sum or through periodic payments.

Taxation of Non-Qualified Annuity Distributions

When money is withdrawn from a non-qualified annuity, specific tax rules apply, primarily the “last-in, first-out” (LIFO) rule. Under this rule, earnings are considered to be withdrawn first and are taxed as ordinary income. Only after all earnings have been withdrawn does the original principal, or the after-tax contributions (cost basis), begin to be returned tax-free.

Withdrawals made before the owner reaches age 59½ are typically subject to an additional 10% IRS penalty tax on the taxable portion (the earnings). There are specific exceptions to this 10% penalty, including distributions made due to the owner’s death or total and permanent disability, or those taken as substantially equal periodic payments (SEPP) over the owner’s life expectancy. Other exceptions may include withdrawals for certain unreimbursed medical expenses exceeding a percentage of adjusted gross income, qualified higher education expenses, or health insurance premiums while unemployed.

The taxation of distributions varies depending on the withdrawal method. For lump-sum withdrawals, all accumulated earnings are taxed as ordinary income in the year received. Partial withdrawals also follow the LIFO rule, with earnings taxed first until they are exhausted. If the annuity is annuitized, meaning converted into a stream of regular payments, each payment is considered partly a return of tax-free principal and partly taxable earnings.

Non-Qualified Annuity Payout Options

Several payout options become available for non-qualified annuities. One common method is “annuitization,” where the accumulated value is converted into a series of regular, guaranteed income payments.

Common annuitization options include “Life Only,” which provides payments for the annuitant’s lifetime and ceases upon their death. Another option is “Period Certain,” guaranteeing payments for a specified number of years, such as 10, 15, or 20 years. If the annuitant dies before the period ends, the remaining payments go to a named beneficiary. The “Joint & Survivor” option provides payments for the lives of two people, typically a spouse or other designated individual, with payments continuing to the survivor after the first person’s death, often at a reduced percentage like 50% or 75% of the original amount.

Beyond annuitization, owners can also opt for “systematic withdrawals,” which involve taking periodic withdrawals of a fixed amount or for a fixed period. Alternatively, a “lump-sum withdrawal” allows the owner to take out all or a portion of the account value at once. These flexible withdrawal methods provide access to funds without committing to an irrevocable income stream.