YOU ASK:

What is the difference between a qualified and a nonqualified annuity?

WE ANSWER:

Let's give a quick rundown of the two kinds of annuities:

Qualified Annuity

This annuity is paid for using pre-tax dollars. The implication of this is that all contributions to the annuity are allowable tax deductions. This means that the contributions can actually put you into a lower tax bracket and give you lower taxable income for the year. When the annuity matures and starts paying, then the entire value of the payout will be applied as ordinary income and will charged taxes.

Qualified annuities are used for retirement plans such as IRAs, Section 403(b) retirement plans and defined benefit pension plans. Thus, these are offered mainly by your employer as part of your salary reduction or pension plan.

Non-qualified Annuity

This is paid for using after-tax dollars. The contributions for the year are not deducted from the year's taxable income. When the annuity matures and starts paying, only the earnings of the annuity will be charged with taxes.

In contrast to a qualified annuity, a non-qualified annuity is not used in conjunction with a  tax-advantaged retirement plan. These are annuities that you buy on your own, as part of your investment portfolio and is not connected with any employer-sponsored retirement plan.

A Comparison

Here is a table outlining the similarities and differences of a qualified annuity and a non-qualified annuity:

Qualified annuity Non-qualified annuity
Penalty for early withdrawals (10% tax) There is penalty for early withdrawals. There is also penalty if you withdraw earnings from the annuity before you reach 59 ½ years of age. This penalty is over and above any other penalties, income tax and contract fees involved.
Tax-deferred earnings Interest earnings are not taxed until the payment period or when more than 10% of the annuity value is withdrawn in a single year. The same applies.
Contributions Paid using pre-tax dollars. Contributions are applied as tax deductions. Paid using after-tax dollars.
Limits on yearly contributions. Yes, you may only pay up to:
  • $5,000 if you are below 50 years old
  • $6,000 is you are 50 years old and above
No limits. Contributions will depend on the value of the annuity.
Rollout of IRA funds You can use a qualified annuity to receive a rollout of any pre-tax retirement plan such as a IRA. Before you can rollover your IRA or any other pre-tax retirement plan, you need to pay taxes on it first.

It is important to understand the difference between the two so that you know which annuity will apply to you.

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