Financial planners and investment advisors, along with the Internal Revenue Service, make a distinction between non-qualified annuities and qualified annuities. Investors, however, are sometimes confused as to what determines whether the funds used to purchase an annuity are non-qualified or not. Non-qualified simply means money that is not part of a tax-deferred account such as a traditional or Roth individual retirement account (IRA), a simplified employee pension (SEP) or an employer sponsored defined benefit plan such as a 401(k). Non-qualified funds are those on which taxes have already been paid and are referred to as “after tax dollars”. They can be, but are not limited to, money kept in a savings or money market account that was earned, or the proceeds received from an inheritance or the sale of a home.
Qualified funds are those available for placement in an Internal Revenue Service (IRS) approved tax-deferred account. Money that is placed in a qualified account must be obtained from earned income. In other words, it cannot be money that was inherited or otherwise given to the annuitant. Contributions to a tax-deferred account can often qualify as tax deductible and have the potential to lower the annuity owner’s current year tax liability. The distribution of income and the taxes paid are deferred until a later point in time, most often after the owner of the annuity has retired.
Under normal circumstances, money that is within a qualified account cannot be withdrawn without penalty before the investor reaches age 59 ½. If an investor chooses to take a premature distribution from a qualified account before he or she is eligible to do so, the IRS imposes a 10% penalty on the amount withdrawn. The money is also taxed as ordinary income in the year the investor withdraws it.
Unfortunately for most investors, ordinary income tax rates are higher than capital gains tax rates. All distributions from qualified accounts, whether they are from annuities, mutual funds, certificates of deposit, or any other investment are always taxed at ordinary income rates.
Immediate and Deferred Non-Qualified Annuities
A non-qualified annuity can be established either as an immediate or a deferred annuity. A large one-time payment, otherwise known as a single premium, is likely to be used to fund a non-qualified immediate annuity. Because taxes have already been paid on the money used to purchase the annuity, only the interest earned on the principal is taxed. For this reason, an immediate annuity can make sense for a retired investor looking to generate a guaranteed stream of monthly or annual income immediately.
A non-qualified variable annuity functions differently. The insurance company invests the premium in stock, bond or money market funds as directed by the annuity owner. The gains then grow tax-deferred until the investor instructs the insurance company to begin distributions. This also differs from other financial investments that are purchased with after tax dollars. For example, the interest earned on a savings or money market account funded with after tax dollars is not tax-deferred.
One advantage of a tax-deferred account is that earnings may grow much more quickly as none of the principal or the gains are being removed from the account to pay income taxes. Another advantage to deferring taxes is that an
investor may be in a lower tax bracket after retirement than he or she was before retirement. This could mean that more dollars are available for the investor to spend as he or she chooses.
Purchasing a non-qualified variable annuity can also provide an additional retirement savings advantage for an investor who has already contributed the maximum dollar amount allowed to a qualified plan. The income from a variable annuity, however, can fluctuate with market conditions. Investors who are not looking to defer income and who seek to receive a fixed amount each month would be better off purchasing a non-qualified immediate fixed annuity.
There is no limit to the amount of non-qualified money that can be placed in an annuity and no limit to the number of annuities that can be purchased. Investors are advised to remember that annuities are contracts, and once purchased, are not liquid.
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Surrendering an Annuity
Almost all annuities have what are known as “surrender charges”. The surrender charge is a sales charge that the owner must pay if he or she chooses to cancel the annuity contract. While each insurance company has its own surrender policy, most will not allow an investor to surrender the contract within six to 10 years from the date of purchase. The surrender charge is usually a percentage of the amount the investor is removing from the contract.
Investors who wish to surrender a non-qualified or qualified variable annuity do have an option, however. Because a variable annuity can suffer a significant decline in value if market conditions are bad, it can be surrendered tax-free through a 1035 exchange. Under Section 1035 of the federal tax code, an annuity can be exchanged for another annuity or life insurance policy without triggering a taxable event, provided the exchange occurs directly between the two insurance companies. This is unlike the “rollover” of other types of tax-deferred assets for which an investor can sell an asset, receive cash and make a new qualified purchase within 60 days.
A 1035 exchange should always be considered if a variable annuity has lost significant value due to a significant decline in value. Section 1035 allows the old inefficient annuity contract to be exchanged for a new, more efficient one.
Reaching Retirement Goals with Non-Qualified and Qualified Annuities
Both non-qualified and qualified annuities can have a place in an investor’s portfolio. But the key is to understand what effects the accumulation and distribution periods will have on the overall financial picture. Setting clear retirement goals and working with a certified financial planner can help an investor purchase the annuity product most suited for his or her financial situation. As always, investors are encouraged to read the annuity prospectus carefully and consult a tax advisor before purchasing or selling
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