What Is a Non-Qualified Annuity & How Is It Taxed?

An annuity is a contract with an insurance company designed to provide a steady income stream, often during retirement. These financial products serve as a way to convert a lump sum or a series of payments into regular disbursements over time. Among the various types, non-qualified annuities represent a specific category funded with money on which taxes have already been paid. This characteristic influences their growth and tax treatment, which differs from other retirement savings vehicles.

Defining Non-Qualified Annuities

A non-qualified annuity is a contract with an insurance company. It is funded with after-tax dollars, meaning contributions have already been taxed. This contrasts with many traditional retirement accounts, which are often made with pre-tax income. Its primary purpose is to offer tax-deferred growth, allowing earnings to accumulate without annual taxation until withdrawals begin.

Individuals often choose these annuities after maximizing contributions to other tax-advantaged retirement plans, such as 401(k)s or IRAs, to save more for retirement or other long-term financial goals. There are generally no IRS-imposed contribution limits for non-qualified annuities, though the issuing insurance company might set its own limits. Non-qualified annuities typically involve two distinct phases: the accumulation phase and the payout phase.

During the accumulation phase, funds grow based on contract terms, and earnings are not taxed until withdrawn. This tax deferral allows for compounding growth. The payout phase begins when the annuity owner starts receiving income from the contract.

How Annuities Grow and Provide Income

Annuities grow through tax deferral, meaning interest, dividends, or capital gains earned are not taxed until withdrawn. This allows earnings to compound, potentially leading to greater growth than in a taxable account where earnings are taxed annually. During this phase, additional contributions can often be made, and money earns interest or investment returns based on the annuity type.

Once the accumulation phase concludes, the annuity transitions into the payout phase, where the owner receives income. There are several ways to receive income from an annuity. One option is a lump-sum withdrawal, where the entire accumulated value is taken out at once. Another method is systematic withdrawals, where the annuity owner receives regular, specified amounts over a period until the funds are exhausted, providing flexibility but not guaranteeing lifetime income.

Alternatively, the annuity can be annuitized, converting the accumulated principal and earnings into a series of periodic payments. These payments can be structured to last for a specific period or for the lifetime of the annuitant, or even joint lifetimes. Common types of annuities include fixed annuities, which offer a guaranteed interest rate; variable annuities, where the value fluctuates based on underlying investment performance; and indexed annuities, which link returns to a market index while offering some principal protection.

Taxation of Non-Qualified Annuities

The taxation of non-qualified annuities is distinct because they are funded with after-tax money. This means that the contributions themselves are not tax-deductible, and when you receive distributions, you will not be taxed again on the principal portion you initially invested. Only the earnings or growth generated within the annuity are subject to income tax.

When withdrawals are made during the accumulation phase, a specific tax rule known as “Last In, First Out” (LIFO) applies. Under LIFO, the IRS assumes money withdrawn first comes from accumulated earnings. These earnings are taxed as ordinary income until the entire gain has been withdrawn. Subsequent withdrawals represent a tax-free return of your original principal.

For annuitized payments, the “exclusion ratio” method determines the taxable portion of each payment. This ratio calculates the percentage of each payment that is a tax-free return of principal and what percentage is taxable earnings. The exclusion ratio is based on factors such as the total investment and expected total return, often determined by the annuitant’s life expectancy. This method ensures the principal is returned tax-free over the payment period, while only the earnings portion of each payment is taxed as ordinary income.

Non-Qualified Versus Qualified Annuities

The primary distinction between non-qualified and qualified annuities lies in their funding source and tax treatment. Non-qualified annuities are purchased with after-tax dollars, meaning the money has already been taxed. Conversely, qualified annuities are typically funded with pre-tax dollars, often through employer-sponsored retirement plans like 401(k)s or individual retirement accounts (IRAs).

A significant difference is the absence of IRS contribution limits for non-qualified annuities, offering more flexibility for higher contributions compared to strict annual limits on qualified plans. While both types offer tax-deferred growth, the taxation of distributions differs. For non-qualified annuities, only earnings are taxed upon withdrawal, as the principal was already taxed. In contrast, all distributions from pre-tax qualified annuities are generally taxed as ordinary income since neither contributions nor growth were previously taxed.

Non-qualified annuities typically do not have Required Minimum Distributions (RMDs), which mandate withdrawals starting at a certain age (currently 73 for most). Qualified annuities, however, are subject to RMD rules similar to other qualified retirement accounts. The choice between these annuity types often depends on an individual’s tax situation, existing retirement savings, and overall financial planning goals.