What Is a Non-Qualified Variable Annuity?

Annuities are financial contracts issued by insurance companies, designed to help individuals save for retirement and secure a steady income stream later in life. These contracts involve an agreement where an individual makes payments to an insurer, either as a lump sum or a series of contributions. In return, the insurance company promises to make regular payments back to the individual, either immediately or at a future date. Annuities serve as a tool for retirement planning, offering a way to accumulate funds and then convert them into a predictable income.

Understanding Non-Qualified Variable Annuities

A non-qualified variable annuity is a contract between an individual and an insurance company, functioning as both an investment and an insurance product. The “variable” aspect means the annuity’s value fluctuates based on the performance of underlying investment options chosen by the contract holder. These options are typically sub-accounts, similar to mutual funds, holding securities like stocks, bonds, and money market instruments. The “non-qualified” aspect means the annuity is funded with after-tax money, distinguishing it from annuities within tax-advantaged retirement plans like 401(k)s or IRAs.

A non-qualified variable annuity typically involves two phases. The accumulation phase is when the individual makes contributions, which are invested in chosen sub-accounts. Earnings within the annuity grow on a tax-deferred basis, with the value increasing or decreasing based on investment performance.

The payout, or annuitization, phase begins when the contract holder starts receiving income payments. This income can be received as regular payments for a specified period or for life. The payment amount varies based on sub-account performance during accumulation and the chosen payout option. While variable annuities offer growth potential through market exposure, they also carry investment risk, as value can decrease if sub-accounts perform poorly.

Key Features and Components

Non-qualified variable annuities include several integral features. A core component is the use of sub-accounts, which are the underlying investment options within the annuity. These sub-accounts function like mutual funds, allowing investment in diversified portfolios. The contract holder selects these sub-accounts and allocates funds, influencing growth potential and risk.

Annuities often include a death benefit. This ensures that if the owner passes away during the accumulation phase, a designated beneficiary receives a specified amount. The death benefit commonly pays the greater of the contract’s accumulated value or total premiums paid, minus prior withdrawals. Some contracts offer enhanced death benefits, such as a “stepped-up” benefit, which may lock in gains, but often come with additional fees.

Many variable annuities offer optional living benefit riders. These come with additional costs but can offer protection against market downturns or ensure a minimum income stream. Common riders include the Guaranteed Minimum Withdrawal Benefit (GMWB), allowing regular withdrawals of a set percentage of the initial investment regardless of market performance. The Guaranteed Lifetime Withdrawal Benefit (GLWB) guarantees income for life.

Other living benefits include the Guaranteed Minimum Income Benefit (GMIB), which guarantees a minimum income stream in the payout phase. The Guaranteed Minimum Accumulation Benefit (GMAB) ensures the annuity’s value will not fall below a predetermined minimum after a specified period, often 10 years. These riders are typically chosen when the contract is established.

Variable annuities also come with various fees and charges that can affect the overall return. These include mortality and expense (M&E) risk charges, which compensate the insurance company for insurance guarantees and administrative costs. Sub-account management fees are similar to mutual fund expense ratios. Administrative fees cover contract management. Additionally, separate fees are charged for optional riders, and surrender charges may apply if funds are withdrawn within a certain period, often 5 to 10 years.

Taxation of Non-Qualified Variable Annuities

The tax treatment of non-qualified variable annuities is significant due to their tax-deferred growth. During the accumulation phase, earnings are not taxed annually. Taxes are deferred until funds are withdrawn or payments begin, allowing the investment to grow more rapidly.

When withdrawals are made, the IRS applies a “Last-In, First-Out” (LIFO) rule. Earnings are considered withdrawn first, before the original principal. Therefore, any amount withdrawn is fully taxable as ordinary income until all accumulated earnings have been distributed. Once earnings are exhausted, subsequent withdrawals are a return of the original, after-tax principal, which is not taxed again.

Upon entering the payout phase, a portion of each payment is considered a tax-free return of principal, while the remainder is taxed as ordinary income. An exclusion ratio determines the taxable and non-taxable portions, spreading tax liability over the payment period.

Withdrawals before age 59½ are generally subject to an additional 10% federal income tax penalty on the taxable portion. Exceptions exist, such as withdrawals due to death or total and permanent disability, or if payments are part of a series of substantially equal periodic payments.

When the annuity owner dies, the death benefits paid to beneficiaries are also subject to specific tax rules. For non-qualified annuities, only the earnings portion of the death benefit is taxable to the beneficiary as ordinary income. The original principal, funded with after-tax dollars, is received tax-free. The tax liability depends on how the beneficiary receives the funds; a lump sum payout means all taxes on earnings are due at once, while spreading payments over time can defer and distribute the tax burden.

How Non-Qualified Variable Annuities Differ

Non-qualified variable annuities differ significantly from other financial products. These distinctions primarily revolve around their funding, tax treatment, investment characteristics, and insurance guarantees.

Qualified annuities are a primary contrast, funded with pre-tax dollars, typically within employer-sponsored retirement plans or IRAs. All withdrawals from qualified annuities are fully taxed as ordinary income. Non-qualified annuities are funded with after-tax money, and only the earnings portion is taxed upon withdrawal. Qualified annuities are also subject to IRS contribution limits and required minimum distributions (RMDs), while non-qualified annuities generally have no IRS-imposed contribution limits or RMDs.

Comparing non-qualified variable annuities to fixed annuities reveals differences in investment growth and risk. Fixed annuities offer a guaranteed interest rate, providing predictable growth and principal protection. Variable annuities allow investment in underlying sub-accounts exposed to market fluctuations, offering potential for higher returns but also carrying risk of loss.

When compared to traditional mutual funds or brokerage accounts, non-qualified variable annuities offer tax-deferred growth. Earnings in a brokerage account are typically subject to annual taxation. Variable annuities allow these earnings to grow tax-deferred until withdrawal. Mutual funds and brokerage accounts generally do not offer the insurance guarantees, such as death benefits or living benefit riders, that are inherent or optional with variable annuities. However, mutual funds and brokerage accounts typically have lower fees.