What is a non-qualified annuity, and how is it taxed?

A non-qualified annuity is an investment option funded with after-tax dollars, designed to provide a reliable income stream for retirement. Unlike qualified annuities, which are often linked to tax-advantaged accounts like 401(k)s or IRAs, non-qualified annuities are purchased with money that has already been taxed. Understanding how a non-qualified annuity is taxed can help you plan effectively for retirement and avoid any surprises.

1. What Is a Non-Qualified Annuity?

A non-qualified annuity is an insurance product that helps you invest and grow your money tax-deferred, with the option to convert the balance into a stream of income later in life. Key characteristics include:

• After-Tax Contributions: Unlike qualified annuities, a non-qualified annuity is funded with after-tax dollars. This means you’ve already paid taxes on the money before purchasing the annuity.
• Tax-Deferred Growth: While invested in the annuity, your money grows tax-deferred, so you won’t owe taxes on gains, interest, or dividends until you start making withdrawals.
• No Contribution Limits: Unlike qualified accounts like IRAs, there’s no IRS limit on how much you can contribute to a non-qualified annuity. This feature makes it attractive for high-income earners who want to save additional funds for retirement.

2. How Non-Qualified Annuities Are Taxed

Taxation for non-qualified annuities depends on whether you’re taking withdrawals or receiving a payout as regular income, as well as how long you’ve held the annuity. Here’s a breakdown:

Growth and Earnings Are Taxed as Ordinary Income

Only the earnings, interest, and investment gains in the annuity are taxed as ordinary income when withdrawn. The principal (initial contribution) is not taxed again since it was funded with after-tax dollars.

No Capital Gains Tax

Non-qualified annuities do not benefit from the typically lower capital gains tax rate. Instead, all earnings are taxed as ordinary income, which can be higher depending on your tax bracket.

3. How Withdrawals Are Taxed Using LIFO (Last In, First Out)

The IRS uses a Last In, First Out (LIFO) rule for withdrawals, meaning the gains and interest are withdrawn (and taxed) before your initial investment. Here’s how it works:

• Gains First: When you make a partial withdrawal, any gains or earnings come out first and are taxed as ordinary income.
• Principal Last: After all the gains are withdrawn and taxed, you can access the principal, which is tax-free since you already paid taxes on it initially.

For example, if you contributed $50,000 to a non-qualified annuity and it has grown to $75,000, the $25,000 in gains is taxed first upon withdrawal.

4. Taxation During the Payout Phase (Annuitization)

If you choose to annuitize, meaning you convert your balance into a stream of payments, the IRS allows a more tax-friendly approach:

• Exclusion Ratio: The IRS calculates an “exclusion ratio” to determine what portion of each payment is considered a return of principal (non-taxable) and what portion represents earnings (taxable).
• Taxable and Non-Taxable Portions: With each payment, a portion of the payment will be tax-free, while the remaining amount (the earnings portion) is taxed as ordinary income. This division continues until your initial investment (principal) has been fully recovered. Once the principal is fully returned, the entire payment becomes taxable as ordinary income.

This structure can be advantageous for those who want steady income with a known tax burden each year.

5. Early Withdrawal Penalties Before Age 59 ½

If you withdraw from your non-qualified annuity before age 59 ½, the IRS imposes a 10% early withdrawal penalty on top of any income tax owed on the earnings portion.

• Exceptions to the Penalty: Certain situations, such as becoming permanently disabled, may exempt you from the penalty. However, the earnings portion is still subject to ordinary income tax.

6. Inherited Non-Qualified Annuities and Taxation for Beneficiaries

If a non-qualified annuity is passed on to a beneficiary, the taxation rules differ slightly:

• Inherited Annuities Are Taxable on Gains: Beneficiaries owe taxes only on the earnings portion of the inherited annuity. The original principal is not taxed.
• Distribution Options for Beneficiaries: Beneficiaries typically have several options for taking distributions: a lump sum (taxable immediately), over a five-year period, or over their lifetime to spread out the tax liability.

Each option impacts the tax burden differently, so it’s essential to understand which method aligns with the beneficiary’s tax strategy.

7. Comparing Non-Qualified Annuities with Qualified Annuities

The tax treatment of non-qualified annuities differs from qualified annuities in key ways. Here’s a summary of the major differences:

8. Advantages of Non-Qualified Annuities in Financial Planning

Non-qualified annuities offer distinct benefits, especially for people who want additional retirement income options without the restrictions of qualified plans. Here’s how they can benefit your financial plan:

• No Contribution Limits: You can invest as much as you want, which is useful for those who’ve maximized their 401(k) or IRA contributions.
• No RMDs: There’s no requirement to start withdrawals at a certain age, allowing you to keep the annuity untouched for as long as you prefer.
• Tax-Deferred Growth: With tax deferral on gains, your investment can grow faster than it might in a taxable brokerage account.

However, consider that non-qualified annuities are most tax-efficient for those in high-income brackets during their working years but expect a lower tax rate in retirement.

Conclusion

A non-qualified annuity can be a valuable tool for tax-deferred growth and reliable income in retirement, funded with after-tax dollars and allowing you to invest without contribution limits. While gains are taxed as ordinary income when withdrawn, only the earnings portion is taxable — a unique feature that differentiates it from qualified annuities. If you’re looking to diversify your retirement portfolio or maximize tax advantages outside of traditional retirement accounts, a non-qualified annuity can help you reach those goals with greater flexibility in contributions and withdrawals.