While researching your retirement income options, you have probably come across the concept of annuities. Chances are the general idea of annuities is pretty straightforward. But once you start digging deeper and reading through the different annuity terms and concepts, things may start looking a bit more involved.
If you are thinking about buying an annuity, then one decision that you will make is whether to opt for a qualified or a non-qualified annuity. The good news is that these terms apply to all of the different types of annuities: fixed, indexed, variable, and so on.
The difference between the two is the type of money you may put in them: after-tax dollars or income that you haven’t yet paid taxes on, pre-tax dollars.
While this is the essential difference between qualified and non-qualified annuities, knowing the basics of both types can help with making a well-informed decision.
So, let’s get into the basics of a qualified annuity versus a non-qualified annuity.
Qualified annuities are connected to tax-advantaged retirement plans. These retirement plans include IRA accounts, 403(b) plans, and defined-benefit pensions.
The money that you put into a qualified annuity is pre-tax money or in other words, not money you have paid income tax on yet.
So you can declare your premium dollars as an income tax deduction, up to a certain limit set by the IRS. Of course, this also means that the sums of money you withdraw at a later date will be taxable.
If your employer retirement plan is a defined-benefit pension, sometimes your plan will actually purchase qualified annuities as part of your retirement package.
However, you can buy this type of insurance product yourself.
Keep in mind that you can only purchase qualified annuities from earned income. That doesn’t include inheritance money, insurance money, or other sources of financial gain.
Like all annuities, a qualified annuity is meant to serve as a part of your retirement strategy. For this reason, you will be charged a 10% income tax penalty should you make any withdrawals from your qualified annuity contract before you turn age 59.5.
However, one important difference from non-qualified annuities is that the government will make it obligatory to start withdrawing money once you turn 72. These withdrawal requirements are required minimum distributions.
The IRS will base the amounts you must withdraw per year on your life expectancy.
Just like qualified annuities, you can purchase any type of annuity under a non-qualified designation. However, in this case, your premium will be paid with money that you have already paid income taxes on.
This means that when you withdraw your money later, you will only need to pay taxes on the interest earned in your contract.
In the case of non-qualified annuities, there is no limit on the amount of money that you can put into the contract. Moreover, the source of funds is not limited to income earned.
Just like with qualified annuities, you will incur a 10% income tax penalty from the IRS if you withdraw money before turning 59.5. That said, the IRS will not require you to take withdrawals from your non-qualified annuities.
Generally speaking, non-qualified annuities don’t have any withdrawal requirements at any age. But some non-qualified annuity contracts themselves may have some requirements for distributions.
When you buy non-qualified annuities from some insurance providers, some contracts come with forced annuitization or distributions.
If the money is left alone in the contract, some annuities start forced income payments at a certain age. That tends to range from ages 85-100.
What Does This Mean for My Income Taxes?
The most important difference between qualified and non-qualified annuities is the effect they have on your income taxes.
Premiums paid into qualified annuities can be used as tax deductions at the time of purchase. However, the initial premium and the earned interest will later be subject to income taxes, determined by the tax bracket you are in at the time of withdrawal.
As mentioned in the previous section, you will have the obligation to begin withdrawing the money and paying income taxes once you turn 72. The minimum amount you must withdraw will be determined by your life expectancy.
How Do I Decide Between Qualified or Non-Qualified Annuities?
When making a decision about a qualified annuity versus a non-qualified annuity, do a cost-benefit analysis.
This analysis will need to anticipate and consider the tax bracket you fall into now versus the tax bracket you expect to be in when you are retired or over the age of 72.
Non-qualified annuities will only incur taxes on their interest earnings. The money put into the contract was already subject to taxation and will be considered a return of capital once withdrawn.
Typically, you will need to pay taxes on the initial sum of money that you withdraw, which will be considered earned interest. The rest of the sum may not be subject to taxes.
Some Final Thoughts to Consider
You may have the benefit of having a qualified plan as part of your employer-sponsored retirement plan. But should someone own a qualified annuity, it’s more likely to be from an individual purchase.
That being said, they do present an important option among the options for tax-smart retirement strategies.
Non-qualified annuities are a good choice for those wishing to potentially reduce their tax burden in retirement. But this depends on what your tax bracket is likely to be when you start drawing income from your contract.
If your tax bracket will most likely fall below your current tax bracket, a qualified annuity may make sense for your situation. Consult with a knowledgeable financial professional to determine what may be right for you.
If you are ready for professional guidance, a financial professional at SafeMoney.com can help you. Use our “Find a Financial Professional” section to connect with someone directly. Should you need a personal referral, call us at 877.476.9723.