What Is a Non-Qualified Annuity?

Annuities are increasingly popular retirement planning products that offer a guaranteed and consistent income stream during your golden years. Among the various types of annuities available, non-qualified annuities stand out for their distinctive tax treatment and flexible contribution options. The following article will consist of an in-depth examination of non-qualified annuities, helping you understand their features, benefits, and potential drawbacks.

What is an Annuity?

An annuity is a financial product that is defined by a contract between the policyholder and a given insurance company, aiming to provide a steady income stream during retirement. Once you contribute to an annuity through a lump-sum or series of payments, the insurer agrees to provide you with regular disbursements, beginning either immediately after purchase or deferred to a future date. Essentially, an annuity offers a reliable source of income over a specified period or for life, often when other revenue streams begin to dwindle, making it a beacon of financial stability in your latter years.

What is a Non-Qualified Annuity?

A non-qualified annuity is a specific annuity type that determines how your income stream will be taxed during retirement. Contributions to a non-qualified annuity are made with after-tax dollars. As a result, upon withdrawals, only earnings are subject to income tax. Unlike qualified annuities, which are financed with pre-tax funds and come with IRS regulations and contribution limits, non-qualified annuities do not have any contribution limits imposed by the IRS. This may increase their appeal to investors looking to contribute a sum exceeding their retirement accounts.

How Does a Non-Qualified Annuity Work?

Since a non-qualified annuity is procured with after-tax dollars–meaning the funds used to buy the annuity have already been taxed–your returns on principal are not taxable. Only the earnings, which include interest, dividends, and capital gains, are subject to income tax, potentially alleviating tax burdens in retirement. Non-qualified annuities also provide tax-deferred growth, meaning taxes are not applied to earnings until withdrawals.

They can be structured to provide payments either immediately upon purchase or at a later (predetermined) date, offering personalized options in regard to how and when you receive income. The taxable and non-taxable portions of your income are calculated through an exclusion ratio, which indicates the percentage of each payment that would be considered a return of principal versus taxable earnings.

Types of Non-Qualified Annuities

If your annuity is non-qualified, this merely determines its tax process and not the specific features associated with it. Hence, a non-qualified annuity offers many of the traditional annuity types, primarily including:

• Fixed Annuities: Provide a guaranteed interest rate for a period of time chosen by the annuitant, often for life. Returns from this annuity type are steady and predictable.

• Variable Annuities: Enable you to link your annuity to various sub-accounts (of your choice), similarly to mutual funds. Variable annuities come with a higher return potential but also higher risk, as your income is likely to fluctuate over the course of your annuity’s term.

• Indexed Annuities: Offer returns based on the performance of a predetermined market index. This option serves as a hybrid between fixed and variable annuities, as it offers profit potential while also providing stability by guaranteeing a minimum rate of return regardless of market fluxes.

• Immediate Annuities: Begin payouts shortly after purchase, typically within a year. This annuity type is ideal for those who have already reached retirement age or need immediate income at the time of purchase.

• Deferred Annuities: Delay payouts to a future (predetermined) date, allowing for long-term accumulation within the annuity and interest-based earnings.

Read more about different annuity types here.

Features of a Non-Qualified Annuity

Let’s take a look at the key characteristics of a non-qualified annuity:

• Tax-deferred growth on earnings

• No contribution caps or RMDs (Required Minimum Distributions)

• Flexible premium disbursement options, allowing for single or multiple payments

• Death benefit options for beneficiaries

• Optional riders for additional benefits and further personalization

Should You Buy a Non-Qualified Annuity?

Consider purchasing a non-qualified annuity if you seek a dependable income stream in retirement. Since this type of annuity comes with a unique set of tax benefits, particularly tax-deferred growth, it can be advantageous to investors who are currently in a high tax bracket but expect to be in a lower one in retirement, allowing them to fully benefit from this tax deferral. Additionally, if you’re looking to pay less taxes during your golden years, opting for a non-qualified annuity (over a qualified annuity) may be more advisable.

Pros & Cons of a Non-Qualified Annuity

Non-Qualified Annuities vs. Qualified Annuities

While non-qualified annuities are purchased with after-tax funds and offer tax-deferred growth on any accumulated earnings, qualified annuities are paid for with pre-tax dollars and provide upfront tax deductions. For a detailed comparison between the two, check out our article on “Qualified vs. Non-Qualified Annuities” here.