What Is a Non-Qualified Annuity and How Does It Work?

Annuities are financial contracts established with an insurance company, designed for long-term savings and to provide a consistent income stream, often during retirement. They allow individuals to accumulate funds and then convert them into a series of payments over a specified period or for life.

Defining Non-Qualified Annuities

A non-qualified annuity is a contract between an individual and an insurance company, distinguished by how its contributions are taxed. Unlike retirement accounts such as 401(k)s or Individual Retirement Accounts (IRAs), non-qualified annuities are funded with after-tax dollars, meaning contributions are not tax-deductible. This allows for greater flexibility in contribution amounts compared to tax-advantaged retirement plans.

The term “non-qualified” indicates that the annuity is not part of an employer-sponsored retirement plan or an IRA, and thus does not receive the same upfront tax benefits or contribution limits. Earnings within the contract grow tax-deferred, meaning they are not taxed annually until funds are withdrawn. This deferral allows earnings to compound over time without being reduced by annual taxation.

Because initial contributions are made with after-tax money, only the earnings component of withdrawals will be subject to income tax. This contrasts with “qualified” annuities, where both contributions and earnings are typically taxed upon withdrawal.

Unlike many qualified retirement plans, non-qualified annuities are not subject to required minimum distributions (RMDs) during the owner’s lifetime. This provides individuals with greater control over when they access their funds, allowing for prolonged tax-deferred growth.

Operational Aspects and Types

A non-qualified annuity operates in two distinct phases: the accumulation phase and the payout phase. During the accumulation phase, funds are contributed and grow on a tax-deferred basis.

The payout, or annuitization, phase begins when accumulated funds are converted into a stream of income payments. This conversion can be initiated at a chosen future date, offering flexibility for when income is needed. Once annuitized, these payments are typically irrevocable.

Non-qualified annuities come in several common types, each offering different growth potential and risk profiles. Fixed annuities provide a guaranteed interest rate for a specified period or for the life of the contract, offering predictability and stability. Variable annuities allow their value to fluctuate based on the performance of underlying investment sub-accounts selected by the annuity owner, carrying investment risk as the account value can increase or decrease with market performance. Indexed annuities link their growth to a market index, such as the S&P 500, often including features like a floor to protect against losses or a cap to limit gains.

Tax Implications

Earnings within a non-qualified annuity grow on a tax-deferred basis, with no income tax due on investment gains until money is withdrawn. This deferral allows earnings to compound over time without being reduced by annual taxation.

When withdrawals are made, the Internal Revenue Service (IRS) generally applies the “Last-In, First-Out” (LIFO) rule for taxation. Under LIFO, earnings are considered withdrawn first and are subject to taxation as ordinary income. After all earnings have been distributed, any subsequent withdrawals are considered a return of the original principal, which is tax-free.

For withdrawals of earnings made before the annuity owner reaches age 59½, an additional 10% IRS penalty typically applies, in addition to regular income tax. Exceptions include withdrawals due to the owner’s death, qualifying disability, or distributions as part of a series of substantially equal periodic payments (SEPP) over the life or life expectancy of the owner.

Upon the death of the annuity owner, beneficiaries are generally taxed on the earnings component as ordinary income. Inherited non-qualified annuities do not receive a step-up in basis, meaning accumulated earnings remain taxable to the beneficiary. The principal is returned tax-free to the beneficiaries.

Accessing Funds

Individuals can access funds from a non-qualified annuity in several ways. Partial withdrawals allow the annuity owner to take out a portion of their accumulated funds. These withdrawals are subject to the LIFO taxation rule, meaning earnings are withdrawn and taxed first.

Alternatively, an owner can opt for a full surrender of the annuity, cashing out the entire contract value. This may incur surrender charges, which are fees imposed by the insurance company for early withdrawals, especially if the surrender occurs within an initial contract period, typically ranging from three to ten years. These charges often start higher in the first few years, potentially around 7% to 8% of the amount withdrawn, and gradually decrease over the surrender period. Many contracts allow a penalty-free withdrawal of a certain percentage, commonly 10% of the account value, each year.

The most common method for accessing funds as a regular income stream is through annuitization. This process converts the accumulated annuity value into a series of periodic payments. Various annuitization options exist, such as “life only,” which provides payments for the annuitant’s lifetime, ceasing upon their death. “Period certain” options guarantee payments for a specific number of years, even if the annuitant dies earlier, with any remaining payments going to a beneficiary. A “joint and survivor” option provides payments for the lives of two individuals, typically a spouse and the annuitant, continuing for the survivor’s lifetime.

Once an annuity is annuitized, the chosen payment structure is generally irrevocable. During annuitization, each payment received is typically considered partly a tax-free return of principal and partly taxable earnings, determined by an exclusion ratio calculation.