There are different types of annuities as discussed in our previous article talking about all things annuities. For example there are immediate annuities and deferred annuities. There are fixed interest annuities, indexed annuitiesย and variable annuities. However, the type of annuity is NOT a factor in the world of qualified and non-qualified annuities.
Regardless of the type of annuity, ALL can be classified as either a qualified annuity or a non-qualified annuity. The difference between qualified and non-qualified annuities relates to an important tax distinction and this is the focus of today’s topic.
Qualification vs. Type of Annuity [A Brief Review]
When people talk about types of annuities, it mostly refers to the approach to calculating the growth of the cash in the account OR when the account will convert into an income stream. When we’re talking about the formula for growth, we will define an annuity is either a fixed interest annuity, indexed annuity or a variable annuity.
When we’re referring to when the annuity will convert into a stream of income, we’re talking about whether the annuity is an immediate annuity or a deferred annuity.
Process of the annuity converting into a regular stream of income is referred to as annuitization.
All annuities have what is called an Annuity Start Date (ASD), noting that immediate annuities just start right way vs. the deferred annuity that is set to start at a later date.
With these concepts (referring to the types of annuities) now firmly in your grasp, it is important to remember that none of these is exclusive to either qualified or non-qualified annuities.
Tax Deferred vs. Qualified Annuities
Another important aspect of ALL annuities that needs to be pointed out now is the “tax deferred” character of annuities. My reasoning for pointing this out now is that it is easy to get confused and think that only qualified annuities offer tax advantages and this is NOT the case.
All annuities offer tax deferred growth similar to other IRS approved financial vehicles such as IRA’s orย 401(k)s.
Cash value life insurance policies also offer tax deferred growth of cash value.
So, when we dive into describing the important tax advantages of qualified annuities, remember that nothing else concerning annuities is any different in terms of the type OR tax deferred growth.
One important tax distinction will be made which does impact the tax deferral benefit. Time to pull back the curtain.
Another aspect of avoiding confusion is that a 1035 exchange can be used for both qualified and non-qualified annuities and simply means that the account can be moved to a similar product without taxation in the same way as used for other life insurance products. Notably, a life insurance contract can be rolled into an annuity but NOT the other way around.
The Qualified Annuity vs. the Non-Qualified Annuity
Pros and Cons
Understanding the Qualified Annuity
The key to understanding a qualified annuity is to know that these are ALWAYS used in connection with a qualified retirement plan or an IRA, or perhaps a defined benefit plan (i.e. deferred compensation plan), or a 403(b) account, TSA account. Premiums for qualified annuities are paid with pre-tax dollars whereas all other types of annuity premiums are paid with after-tax dollars.
The important point to understand is that any annuity that is not used for funding a tax advantaged retirement plan is defined as a non-qualified annuity. The annuity products are otherwise exactly the same.
Pros of Qualified Annuities
The pros of qualified annuities are essentially the same as those for qualified retirement accounts in general. The primary pro is of course the tax deductible premiums OR put another way, the ability to pay premiums with pre-tax dollars.
This ability to pay premiums with pre-tax dollars is a big pro because the money used to fund the annuity payment is not-subject to taxes first and thus, a bigger annuity (or income stream) can be purchased pre-tax.
A direct benefit is being able to fund more tax deferred growth due to avoiding taxation on the premiums paid in. This pro is a core benefit of all qualified retirement accounts.
The fact that premium payments are deductible means that either an employer or an individual is deducting the annuity premiums and the employee is simultaneously not realizing any income for this amount.
This can be a key business planning advantage for small business owners as part of a key person retention plan or family business planning strategy.
Cons of Qualified Annuities
The same rules apply to regulate qualified annuities as pertaining to other qualified accounts such as IRAs, 401(k)s, etc. Qualified accounts DO NOT allow access to the cash without a 10% penalty until age 59 1/2 and mandatory withdrawals are required at age 70 1/2.
Distinguishing Other Tax and Contractual Requirements
Remember that these tax rules and penalties that are related to qualified annuities are IN ADDITION to tax penalties that concern ALL types of annuities such as early withdrawal tax penalties realized under the last in first out (LIFO) method discussed below.
Also, the tax rules around annuities are entirely separate from the contractual penalties that may be assessed by the insurance company for early withdrawal or surrender of the contract.
Survivorship Advantages of Qualified Accounts
As a practical matter, the requirements for required minimum distributions (RMDs) may NOT be entirely negative when it comes to annuities due to the survivorship benefits of qualified accounts.
As an estate planning matter, non-qualified annuities lack rollover options AND, although they may offer some survivorship benefits, generally are characterized by unfavorable tax treatment for beneficiaries.
For example, unlike life insurance and real estate investing, there is “no step up in basis” and there is income tax exposure for the estate upon the death of the annuity owner.
The point being, perhaps qualification of annuity premiums may be even more advantageous (as opposed to non-qualified options) than for other types of unqualified investments such as life insurance or Roth IRAs.
Understanding the Non-Qualified Annuity
Non-qualified annuities are purchased with after tax money and thus the rules are very different. Unlike the I.R.S. rules governing life insurance contracts, the tax rules for non-qualified annuities are still somewhat complicated.
The likely reason for this is life insurance is viewed as using cash to purchase a death benefit, whereas an annuity is all about converting a lump sum into an income stream.
The I.R.S. has thus made significant effort to make sure that this strategy does NOT become an end run around taxes.
LIFO Method of Annuity Income Taxation
If money from an annuity is taken early, which is known and either a partial or total “surrender” of the contract, the I.R.S. categorizes this amount first as earnings, subject to regular income taxes.
After all earnings have been taken out first, then the balance of the annuity that was paid in as premiums can be taken tax free as a return of capital.
This is known as the “last in, first out method” of annuity taxation. This rule is actually a reversal of an earlier historical approach known as the “first in, first out” approach, which was deemed to constitute an unfair advantage and thereafter reversed by the I.R.S.
Contractual Penalties for Early Withdrawal
All annuities are based upon the premise that the money will remain in the account for a predetermined minimum contractual period of time (usually 7-9 years). Sometimes contracts allow for early withdrawal up to a certain maximum percentage (usually 10%).
Outside of these parameters, there is always a contractual penalty set by the insurance company for early withdrawal and this has NOTHING to do with taxes.
Pros of Non-Qualified Annuities
The key pro of non-qualified annuities, as with most other non-qualified investments such as permanent life insurance, is more flexible access to the cash due to the absence of age restrictions and the 10% tax penalty.
For example, early withdrawal options would not be available with qualified annuities. However, a critical point on this issue is that the I.R.S. still institutes a 10% penalty for withdrawals made before age 59 1/2 from a non-qualified annuity.
This fact supports my point above that qualification of the account may offer an even greater benefit for annuities than other types of retirement accounts and other strategies for retirement using life insurance.
Of course, tax deferral is still available as a contractual structure that can guarantee a return on investment as an income stream for a set contractual period of time.
Cons of Non-Qualified Annuities
The key con of non-qualified annuities is alluded to several times above and basically says, there are lots of I.R.S. restrictions on these accounts anyway, so why not fund them with pre-tax dollars?
Whatever your search leads, I hope you now have a solid grasp of the differences between the genre of qualified vs. non-qualified annuities.
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