A Complete Guide to Non-Qualified Annuities to Create Strong Retirement Plans
Qualified and non-qualified annuities are essential elements to understand before buying an annuity. Many policyholders are unaware of nonqualified annuities; however, individuals devising a retirement plan should know about this helpful asset before purchasing a new annuity. Depending on your situation, you may benefit significantly from investing in a non-qualified annuity.
Given the fantastic potential a nonqualified annuity presents for many policyholders, we’ve compiled an ultimate guide to understanding all things nonqualified annuities, including how it differs from a qualified annuity, the unique advantages of a nonqualified annuity, and how to measure your options when making this decision. Let’s get started!
What are Qualified Annuities?
Before understanding how a nonqualified annuity differs from other types, you must know what you compare it to. Qualified annuities include assets like a traditional Individual Retirement Account (IRA) or your 401(k) plan. These annuities are tax-deferred, as the annuity is tax-qualified. Therefore, qualified annuities can grow faster than nonqualified annuities and a qualified annuity can increase significantly after some time.
While qualified annuities are helpful for many people, this option has some restrictions, such as contribution limits and taxes incurred when policyholders withdraw money from their annuity.
What are Non-Qualified Annuities?
Non-qualified annuities are annuity contracts not qualified as retirement savings products that the policyholder can only fund with after-tax dollars rather than tax-deferred dollars. These annuities are often considered tax-free annuities. Though individuals don’t receive tax deductions for money contributed to a nonqualified annuity account, their account still grows without incurring additional taxes until taking the money out of the account. This is possible because you have already paid taxes on the money going into your nonqualified annuity account.
Non-qualified annuities are helpful for many people looking to put additional money toward their retirement and life savings outside of their maxed-out 401(k) or IRA accounts. Nonqualified annuities are purchased outside of an employer’s retirement plan, and individuals can begin making withdrawals at age 59. A qualified annuity purchased with pre-taxed dollars will incur much higher deductions than an annuity paid after tax.
How Does a Non-Qualified Annuity Work?
While getting a nonqualified annuity might seem challenging, it’s relatively straightforward when you know what to expect. A nonqualified annuity offers a tax-deferred investment to help people reduce their tax bill upon retirement. Like other annuities, a nonqualified annuity goes through the following growth stages:
- Accumulation: the accumulation stage describes the period where your contributions to a non-qualified annuity account grow based on how it’s been invested.
- Distribution: in the distribution process, you begin receiving distributions via withdrawals or scheduled payments.
The Primary Features of Non-Qualified Annuities
A nonqualified annuity is defined by a few characteristics that separate it from qualified annuities. For example, the following are some notable features of a non-qualified annuity to expect from the process.
- Non-qualified annuities are not tied to employer-sponsored retirement accounts.
- Some ways that individuals can buy nonqualified annuities include mutual funds, savings accounts, and certificates of deposit (CDs).
- Non-qualified annuity policyholders don’t need earned income, which differs from policyholders with a qualified annuity.
- Non-qualified annuities are beneficial because there is no annual limit for your contributions. In some cases, your annuity provider might set their limits.
- Federal income tax is paid only on the earnings from nonqualified annuities, and the principal and premiums aren’t taxed.
- Individuals that own a nonqualified annuity do not need to take any required minimum distributions. Initially, withdrawals from the account will accumulate interest on the policyholder’s earnings. Following this period, you receive the money upfront and the premiums paid.
- While early withdrawals for nonqualified annuities might incur an early withdrawal penalty, policyholders typically take less of a hit to their finances if they withdraw early compared to canceling a qualified annuity. When withdrawing early from a qualified annuity before age 59, individuals will face a 10 percent tax penalty that often applies to the total sum; however, when withdrawing from a nonqualified account before age 59, earnings and interests are the only things subject to the penalty.
The Types of Non-Qualified Annuities
There are variations of nonqualified annuities with different terms and expectations to consider if you’re interested in this policy. Below is a breakdown of the variations of nonqualified annuities to help you decide the best type of annuity for you.
Immediate and Deferred Annuities
Immediate anddeferred annuitiesare two options for a non-qualified policy. An immediate annuity requires you to pay a lump sum upfront, allowing you to start receiving your payments immediately.
Deferred annuities do not provide immediate payments like the previous option. However, with a deferred annuity, individuals can grow tax-deferred funds and contribute throughout their lives. Consider the following benefits of deferred annuities:
- More withdrawal flexibility
- Improved estate planning
- Tax deferral benefits
- Guaranteed income stream
- Protection from market volatility
- Portfolio diversification
Fixed, Indexed, and Variable Annuities
Other nonqualified annuities include fixed, indexed, or variable ones. Below is a breakdown of each option to help you assess the risks and determine the most appropriate for your financial situation.
- Fixed Annuity: A fixed, nonqualified annuity offers policyholders a regular interest rate. Fixed annuities are low-risk compared to many other investment options and provide an ideal option for individuals that want to secure stable finances rather than gamble.
- Indexed Annuity: An indexed annuity is a middle-ground between fixed and variable annuities and offers a higher rate than fixed annuities. These annuities are less market-based than variable, and individuals can grow their finances without excessive risk of negative returns. Some indexed annuities are capped; however, this is not true for many providers.
- Variable Annuity: Variable annuities are riskier investments involving stocks and bonds. These annuities are vulnerable to market fluctuations, and individuals take a significant risk to earn more in the long term, including surrender penalties. Earnings with variable annuities are entirely based on how well your investments perform. If you have a higher risk tolerance and ample funds, this option might appeal to you more than individuals looking to keep it safe.
Required Minimum Distributions for Non-Qualified Annuities
Nonqualified annuities do not have any required minimum distributions, unlike qualified annuities. A qualified annuity requires that a policyholder withdraws funds by the age of 72. Without a minimum distribution requirement, non-qualified annuities are far more flexible and suitable for many people.
Do I Need a Non-Qualified Annuity?
The answer depends on your situation and how you respond to a few decisive factors of non-qualified annuities. Ultimately, it’s always best to consult your insurance company or connect with a financial professional before determining whether you will pursue a non-qualified annuity.
If you’re looking for lifetime income and have maxed out your qualified annuities, a non-qualified annuity might suit you, especially if you prefer to use after-tax dollars to fund your account. Additionally, a non-qualified annuity is worth exploring if you prefer fewer tax consequences.
Taxation for Qualified vs. Non-Qualified Annuities
As you know, the taxation policies for qualified and non-qualified annuities differ significantly. Below is a breakdown of the taxation process for each option to give you a clearer idea of what to expect from your choice.
Qualified Annuities
- Funding: qualified annuities are typically funded with pre-tax dollars, though Roth annuities are exempt from this and can be funded with after-tax funds.
- Distribution: a qualified annuity follows the Required Minimum Distribution (RMD) policy except for Roth IRA plans. Individuals must take a distribution by April 1st of the year following their 72nd birthday. Employer-qualified annuities are not subject to this rule if you are still working.
- Payouts: Payouts on qualified annuities require you to pay regular income tax on your distribution, unlike non-qualified annuities.
Non-Qualified Annuities
- Funding: non-qualified annuities grow tax-deferred.
- Distributions: these annuities are exempt from the RMD policy.
- Payouts: policyholders for non-qualified annuities have their earnings taxed as ordinary income but do not pay taxes on premiums and principals like qualified policyholders.
What to Consider for Your Retirement
Before deciding on an annuity plan, consider how you will receive your funds upon retirement. The following are three options for annuitants to receive funds and ensure that their retirement plans are practical:
- Receiving a lump sum of money upon retirement. This option could move you into a higher tax bracket and result in outstanding tax liability, so proceed cautiously.
- A fixed amount for a specified period of time
- Fixed, scheduled lifetime payments
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