What Is a Nonqualified Annuity & How Is It Taxed?

Annuities are financial contracts offered by insurance companies that provide a steady income stream, often during retirement. Individuals typically purchase annuities with a single lump-sum payment or through a series of payments. They accumulate funds on a tax-deferred basis and then distribute them in regular installments, which can last for a specific period or for life.

Understanding Nonqualified Annuities

A nonqualified annuity is a contract between an individual and an insurance company, distinct primarily by how it is funded. Unlike qualified annuities, which are typically part of employer-sponsored retirement plans like 401(k)s or IRAs and are funded with pre-tax dollars, nonqualified annuities are purchased with after-tax dollars. This means the money contributed has already been subject to income tax, and contributions are not tax-deductible.

The core components of a nonqualified annuity include an accumulation phase and a payout phase. During the accumulation phase, the principal grows on a tax-deferred basis, meaning earnings are not taxed until withdrawn. Nonqualified annuities do not have IRS contribution limits and are not subject to required minimum distributions (RMDs) at age 73, providing flexibility in when funds must be withdrawn.

How Nonqualified Annuities Operate

A nonqualified annuity begins with the accumulation phase, where premiums are paid into the contract. These can be a single lump sum or a series of payments. During this phase, the money grows, with earnings accruing on a tax-deferred basis, meaning no taxes are paid on the growth until withdrawals begin. This allows earnings to grow more rapidly due to compounding.

Early withdrawals may incur surrender charges, which are fees imposed by the insurance company to discourage early withdrawals. These charges can be substantial, often starting at 7% to 10% of the withdrawn amount in the first year and decreasing annually over a surrender period, which commonly lasts from five to ten years. Many contracts offer a “free withdrawal” provision, allowing policyholders to withdraw a certain percentage, often around 10% of the account value, annually without incurring surrender charges.

Following the accumulation phase, the annuity enters the payout phase, where accumulated funds convert into a stream of income payments. Payouts can be immediate or deferred. Options include payments for a fixed period, for the annuitant’s lifetime, or for the joint lives of the annuitant and a beneficiary.

Tax Implications of Nonqualified Annuities

The tax treatment of nonqualified annuities distinguishes them from other financial products. Since they are funded with after-tax dollars, the original principal is not taxed again upon withdrawal. However, any earnings generated within the annuity are subject to taxation as ordinary income upon withdrawal.

Withdrawals from a nonqualified annuity in the accumulation phase are generally taxed on a “last-in, first-out” (LIFO) basis. This means the IRS considers earnings to be withdrawn first, and these earnings are fully taxable as ordinary income until all accumulated gains have been distributed. Only after all earnings have been withdrawn does the return of the original, after-tax principal occur, which is tax-free.

A 10% federal income tax penalty typically applies to the taxable portion of withdrawals made before the annuity owner reaches age 59½, in addition to ordinary income tax. Exceptions include withdrawals due to the owner’s death or disability, or as part of a series of substantially equal periodic payments.

Upon the death of the annuity owner, death benefits paid to beneficiaries are generally subject to income tax on the earnings portion. Unlike life insurance death benefits, there is no “step-up” in basis for income tax purposes. Beneficiaries receiving lump-sum payments are taxed similarly to partial withdrawals, while annuitized payments are taxed as received, with each payment containing a taxable earnings portion and a tax-free return of principal.

Individuals can transfer funds from one nonqualified annuity to another without incurring immediate tax liability through a Section 1035 exchange. This provision of the Internal Revenue Code allows for a tax-free exchange of an annuity contract for another annuity contract, enabling owners to switch to a new annuity while continuing tax-deferred growth.

Variations of Nonqualified Annuities

Nonqualified annuities come in several forms, each with different risk and return characteristics.

Fixed Annuities

Fixed annuities provide a guaranteed interest rate for a specified period, offering predictability and lower risk. The principal and interest growth are guaranteed by the issuing insurance company.

Variable Annuities

Variable annuities allow the owner to invest in various sub-accounts, similar to mutual funds. Their value fluctuates based on the performance of these investments. These products often have higher fees compared to fixed annuities due to investment management.

Indexed Annuities

Indexed annuities, also known as fixed-indexed annuities, offer a hybrid approach. Their growth is linked to a market index, such as the S&P 500, but they include a principal protection feature. This means the annuity value will not fall below a certain point even if the market index declines. However, upside growth is often subject to caps or participation rates, limiting the maximum return.

Ownership and Beneficiary Designations

The ownership of a nonqualified annuity can be structured in several ways, including individual ownership, joint ownership, or ownership by a trust. Joint ownership means that the death of any joint owner may require a distribution of the contract, potentially within five years if not in payout status. Annuities owned by non-natural persons, such as corporations or trusts, generally do not receive tax deferral on gains, with earnings taxed annually, unless the trust acts as an agent for a natural person.

Designating beneficiaries for a nonqualified annuity is an important aspect of financial planning, as it determines who receives the remaining value of the contract upon the owner’s death. Proper designation helps ensure funds are distributed according to the owner’s wishes and can help avoid probate.

Beneficiary options include a lump-sum payment, distribution over a five-year period, or a “stretch” payout over the beneficiary’s life expectancy. For a surviving spouse, there is often the option to continue the annuity contract as the new owner, maintaining its tax-deferred status. The flexibility to change beneficiaries typically remains with the owner throughout the annuity’s accumulation phase.