Creating a retirement plan involves balancing long-term financial growth with the amount you can contribute to tax-advantaged accounts. Employer-sponsored retirement plans and individual retirement accounts offer important tax benefits. However, these accounts have annual contribution limits that can cap how much you save for retirement.
For those who have already reached these limits or are looking for another way to put their money toward retirement, annuities can offer an additional savings option.
Roger Ibbotson, a finance professor, notes, “Generic FIA [Fixed Index Annuity] using a large-cap equity index in simulation has bond-like risk but with returns tied to positive movements in equities, allowing for equity upside participation. For these reasons, an FIA may be an attractive alternative to (long-term government bonds) to consider.”
Non-qualified annuities, in particular, offer tax-deferred growth while allowing investors to use funds outside of qualified retirement accounts.
What Is a Non-Qualified Annuity?
A non-qualified annuity is an insurance contract, which, unlike many other options, is funded with money after tax deductions. Since the money used to purchase the annuity is already taxed, withdrawals are not taxed fully as ordinary income.
Only the earnings are taxable when withdrawn because the invested amount is the owner's after-tax principal. 1891 Financial Life states that these annuities may provide tax-free income payments after distributions begin.
Non-qualified annuities may appeal to individuals who want to save additional money for long-term financial goals after reaching their 401(k) contribution limits. Depending on the contract terms, they may also offer flexibility in deciding how and when to access the accumulated funds.
Can I move an existing investment into a non-qualified annuity?
Yes, you may transfer or exchange some investments into a non-qualified annuity without creating an immediate tax liability, depending on how the transaction is structured. For instance, a 1035 exchange may allow you to exchange one eligible insurance contract for another while deferring taxes. Be sure to review the applicable requirements before proceeding with the transfer.
Qualified Vs. Non-Qualified Annuity
In a qualified annuity, you fund it with your total income before tax, similar to a 401(k). Non-qualified annuities follow a different tax structure because they are purchased with funds that have already been taxed.
According to Annuity.org, withdrawals are generally taxable only on the portion attributed to investment earnings. The original contributions are generally returned without being taxed a second time. This distinction affects the tax treatment and financial characteristics of each annuity type.
The difference can also affect how contributions and withdrawals fit into a broader retirement strategy.
Qualified annuities follow the rules of the retirement accounts that hold them, including contribution limits and required minimum distributions. Non-qualified annuities offer greater flexibility because of funding from after-tax money and generally have no annual contribution limits.
How Withdrawals Get Taxed
Accessing the funds may involve more tax rules than anticipated. A last-in, first-out (LIFO) approach is used to determine how withdrawals from these annuities are taxed. As Investopedia explains, it withdraws earnings before the original principal. During the accumulation phase, each withdrawal is generally treated as taxable earnings until you distribute all accumulated gains.
Once you withdraw all accumulated earnings, subsequent distributions may be tax-free because they come from the original contributions. If withdrawals are made before someone turns 59½, they may be subject to a 10% federal penalty.
Recent tax law changes have made these financial products more appealing to some retirees. A Medical Economics contributor notes that individuals age 65 and older may be eligible for an additional deduction.
The deduction amount depends on whether an individual's income falls below certain thresholds. Selecting a deferred annuity instead of a taxable Certificate of Deposit (CD) may reduce the amount of income reported annually. This strategy may also reduce the share of a retiree's Social Security benefits subject to taxation.
How do partial withdrawals differ from annuitizing an annuity contract?
A partial withdrawal lets you take out a portion of the annuity's value while keeping the remaining balance invested. Annuitization turns the accumulated value into a regular stream of payments based on the terms of the contract. Since the tax treatment may vary between these options, the way you access the funds can affect your tax liability and future income.
How Non-Qualified Annuities Can Fit Into a Financial Strategy
Non-qualified annuities can work alongside other retirement savings vehicles rather than replacing them. These tax-deferred products may be especially useful after you have reached the contribution limits for 401(k)s and IRAs. They may also appeal to higher-income individuals looking for another way to defer taxes on investment earnings.
This approach is typically better suited to long-term financial objectives than short-term savings. Withdrawal timing also matters, as a large lump-sum distribution could push you into a higher tax bracket.
For instance, someone who regularly maxes out their retirement account contributions may have additional cash to allocate toward retirement. A non-qualified annuity can provide another vehicle for long-term savings while allowing the funds to continue growing on a tax-deferred basis.
Different Types of Non-Qualified Annuities
Non-qualified annuities are available in several types, each with its own features, benefits, and potential risks.
Fixed Annuities
Fixed annuities typically offer a stated interest rate for a set period or use a specific interest-crediting method outlined in the contract. They may suit investors who value predictable growth and want to limit their exposure to market fluctuations.
Variable Annuities
Variable annuities let investors allocate their money across various investment options, so the account value may increase or decrease based on market performance. While they can provide greater growth potential, they also carry investment risk and may include fees and contract provisions that should be reviewed carefully.
Fixed Indexed Annuities
Fixed indexed annuities generally base interest credits on the performance of a selected market index, subject to factors such as caps, spreads, and other contract provisions. Depending on the contract, they may offer growth tied to market performance while providing some protection from direct market losses.
Estate and Beneficiary Considerations
Non-qualified annuities can play a role in estate planning as well. Owners can generally designate beneficiaries who may receive any remaining annuity value after the owner's death, subject to the terms of the contract.
Non-spouse beneficiaries generally must follow a specific IRS distribution timeline after the annuity owner's death. According to CBS News, the full contract value generally needs to be distributed within five years.
This requirement is commonly referred to as the five-year rule for annuity beneficiaries. However, it may not apply when a beneficiary selects another eligible payout option within the specified period. Spouses generally have greater flexibility and may be able to continue the annuity under their own name.
The tax treatment for beneficiaries can vary based on individual circumstances and the type of annuity involved. Investors should periodically review their beneficiary designations and consider consulting qualified tax and estate planning professionals about the potential implications.
Can I designate multiple beneficiaries for a non-qualified annuity?
Many annuity contracts allow owners to name more than one beneficiary and determine how the remaining funds will be distributed among them. The options available can differ depending on the insurer and the terms of the contract. It is important to keep beneficiary details updated, particularly after major life events such as marriage, divorce, or the death of a named beneficiary.
What Investors Should Consider
The flexibility offered by non-qualified annuities can make them suitable for certain financial goals, but investors should consider several factors before purchasing one.
These factors include:
Fees and expenses: Some annuities may charge multiple fees that can reduce long-term returns.
Liquidity: Surrender periods and withdrawal limitations can restrict access to your money.
Tax treatment: Although growth is tax-deferred, earnings are generally taxable when withdrawn.
Investment risk: Risk levels can vary considerably among fixed, variable, and indexed annuities.
Insurance company strength: Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing insurer.
Long-term objectives: Annuities are generally more appropriate for long-term savings goals than short-term financial needs.
Comparing different contracts carefully can help investors understand the trade-offs involved and determine whether the potential benefits align with their financial goals.
Non-Qualified Annuity Facts at a Glance
Funding | After-tax money |
Annual contribution limit | No IRS contribution limit |
Growth | Tax-deferred |
Withdrawal taxation | Earnings are generally taxed first |
Early withdrawal penalty | 10% federal penalty may apply before age 59½ |
1035 exchange | May allow tax-deferred exchange between qualifying contracts |
Non-spouse beneficiary rule | Contract value generally distributed within 5 years |
Non-qualified annuities can offer investors another way to pursue tax-deferred growth without the annual contribution limits that apply to many qualified retirement accounts. Their capacity for larger contributions may be especially helpful for individuals who have already reached the limits of their other retirement savings options.
However, contribution flexibility should be evaluated along with fees, liquidity restrictions, tax considerations, investment risks, and contract provisions. A non-qualified annuity may fit into a broader financial plan, but its suitability depends on an individual's financial goals, investment timeline, and overall circumstances.