Qualified versus non-qualified annuities: Which fits your strategy?

Annuities offer a secure safety profile and long-term growth potential — and most are tax-deferred, meaning you won't be charged by your insurance provider or the IRS unless you withdraw early or it's time to claim your payout.

Although all tax-deferred annuity plans won't charge taxes until distribution, there are a few differences to consider if you opt for a qualified versus non-qualified annuity. Read on to better understand how these annuity types affect tax payments.

What’s a qualified annuity?

Qualified annuities let you fund your account with pre-tax dollars in a retirement plan like an employer-sponsored 401(k) or a traditional individual retirement account (IRA). For this type, you don't have to pay income taxes on your contributions with the former account. 

As a tradeoff, there's limited flexibility since you need to follow IRS rules for yearly contribution limits and required minimum distributions (RMDs). 

What’s a non-qualified annuity?

With a non-qualified annuity, you use money in a taxed account like your savings or a brokerage account (so, after-tax dollars) to fund your investment. Here, you're responsible for paying income tax on all the money you put into your annuity plan. 

Because you're not using a tax-advantaged product to fund your annuity, you have the flexibility to buy your contract independently, and you can pull money for your annuity from any individual taxable account. There are also no limits on how much you can contribute to a non-qualified annuity, and you still enjoy tax-deferred growth.

Critical differences between qualified and non-qualified annuities

Here are some key factors that differentiate qualified and non-qualified annuities. With these differences in mind, you'll know what to expect regarding tax responsibilities, earnings potential, and account flexibility.

Funding source

You can contribute to a non-qualified annuity with any source of after-tax funds, including regular income or personal savings. And qualified annuities link to a source of pre-tax funds from an IRS-approved plan, like an employer-sponsored retirement plan or a traditional IRA.

Tax treatment

You can get tax-deferred qualified and non-qualified annuities, so no matter your choice, you don't pay taxes on your portfolio's earnings. But in the latter type, you'll still have to pay regular income taxes on money you use for contributions. And qualified annuities let you deduct your pre-tax contributions from yearly income tax for extra savings during the accumulation phase.

Once it’s time to pay taxes on withdrawals or payouts, non-qualified annuities are less of a burden since you only have to pay taxes on the gains in your account rather than the principal deposit. For qualified annuities, the entire distribution gets taxed as ordinary income.

Contribution limits

The IRS restricts how much money you can contribute to a tax-advantaged retirement plan each year. For example, a traditional IRA's current annual contribution cap is $6,500 (or $7,500 after your 50th birthday). Non-qualified annuities don't come with these contribution rules. 

Penalties 

You might pay two types of penalties when withdrawing funds from a qualified or non-qualified annuity. 

The first relates to fees an insurance company enforces on its contracts, commonly called surrender charges. These typically apply to early withdrawals, so you’ll pay a percentage of your annuity's value to the issuing company if you withdraw money before your pre-agreed term. The specifics differ between insurers, but many start with the highest possible penalty in the first few years and gradually decrease this percentage each year. And annuity providers may let you take out 10% of your annuity each year without surrender charges for extra liquidity. 

The second class of penalties comes from the IRS, and there are differences between how much you'll pay with a qualified versus non-qualified annuity. Generally, qualified annuities face steeper penalties because of their association with official tax-advantaged retirement plans. If you take money from a qualified annuity before the age of 59½, you must pay the IRS a 10% early withdrawal penalty plus income tax on the entire distribution. While you also have to pay the 10% penalty on non-qualified annuities for early withdrawals, the penalty only applies to the earnings portion rather than the principal. 

In both cases, there are exceptions to early withdrawal penalties. For example, if you qualify for disability or suffer a medical emergency during your annuity's term, some protections might cover penalty charges. The IRS recognizes certain types of hardship as worthy of a penalty-free withdrawal, and annuity contracts may include provisions like long-term care riders for emergencies.

Required minimum distributions (RMDs) 

RMDs are another IRS-related policy qualified annuity holders have to consider. After age 73, the IRS requires a minimum annual withdrawal from your qualified annuity. There's no uniform RMD for every situation, but the IRS has a formula you can use to divide your annuity’s worth by the life expectancy factor for your situation.

Non-qualified annuities don't come with RMD requirements, which gives you greater flexibility when setting payout terms. You could let your funds grow for as long as you want before withdrawing rather than pulling out at the IRS-enforced deadline. 

How to choose between qualified versus non-qualified retirement plans

There are three main things to consider when choosing between qualified and non-qualified annuities:

• How these annuities are taxed: With qualified annuities, you can count contributions as tax deductions, but you must pay taxes on your earnings and principal when you withdraw. Non-qualified annuities don't let you take advantage of tax deductions upfront, but you only pay on your profits when you start taking payouts. Qualified annuities are more attractive if you want to reduce your current taxable income. If you don’t mind paying income taxes on your contributions, you’ll enjoy lower taxation on non-qualified annuity payouts.
• Employer matching benefits: Qualified annuities sometimes offer the benefit of employer contribution matching in retirement plans like 401(k)s. Non-qualified annuities don't provide these extra funds because they're set up independently with after-tax dollars. So, if your employer offers contribution matching, you could choose a qualified annuity to take advantage of this perk.
• ‍Contribution limitations: You have to feel comfortable with more significant IRS restrictions in a qualified annuity, both for how much you can put in your investment and when you must start taking out payments. Non-qualified annuities have less stringent stipulations, allowing you to set higher thresholds and more extended accumulation periods. A non-qualified annuity might offer superior flexibility if the IRS's rules on contribution caps and RMDs don't work for you.

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Annual Percentage Yield (APY) rates are subject to change at any time.

All guarantees are based on the financial strength and claims paying ability of the issuing insurance company. 

SteadyPace^TM is issued by Gainbridge Life Insurance Company (Zionsville, Indiana).