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What You Need To Know About Non-Qualified Annuities

by Derick SullivanJanuary 14, 2023


In the face of the current adverse economic conditions, many would-be retirees are worried about their financial capacity. Inflation remains elevated, matched with skyrocketing interest rates on borrowing. Financial advisers and personal loan management experts may recommend adding more sources of income to cover their living expenses and loan repayments upon retirement.  



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It’s no surprise that many people postpone any retirement plan and get back to the hustle and bustle of the office. A recent survey indicates that retirement delays in the private sector have doubled in the last year.  

However, amidst rampant financial insecurity, more opportunities are being offered in the market. It may not be too late to compare various financial products and get one for retirement. 

Retirement savings accounts and investments are the most common sources of retirement income. But there are more ways to improve your finances while building asset protection. 

Life insurance may be the first thing you consider, but are you familiar with annuities? Research shows that 39% of investors aged 55 and above are not. Although that sounds like a lot, it’s still a notable improvement from 47% in 2014. Of those who do understand these financial plans, over 80% appreciate their value, which is an increase from pre-pandemic levels. 

People are learning powerful lessons from the events of the last two years. This article considers annuities and how they work to provide you with a retirement income. 

What Is a Non-Qualified Annuity?

Annuities are insurance contracts issued by financial institutions like banks and insurance companies, which guarantee a fixed investment fund payout in the future. You can invest in them or purchase them with premiums or lump-sum payments. 

After accumulating funds, you can start receiving payments at a fixed schedule for a specific period or as long as you are alive. Even better, you can structure an annuity into different financial instruments, giving you more flexibility. So, annuities provide an effective retirement income stream if your savings are insufficient. 

Annuities provide a consistent cash flow for annuitants upon retirement in addition to other ordinary income. It assures you of a steady income stream even if you outlive your assets. In the event that more than savings and dividends from investments are needed, it’s a good idea to consider purchasing an annuity contract. 

But before we focus on non-qualified annuities, we must first differentiate annuity products from life insurance. The table below shows the fundamental difference between the two financial products. 

Life Insurance vs. Annuity 

Life Insurance

Annuity

A death benefit, so not a retirement plan. Payout is distributed as long as the recipient is alive.
Dependents receive the income.  Policyholders receive fixed payouts like an income stream. 
Life insurance is not subject to income tax.  Subject to tax, but the extent varies according to type. 

Put simply, annuities are the opposite of life insurance. They can be qualified or non-qualified, which determines how taxes may apply to them. A non-qualified annuity is an investment vehicle bought with after-tax dollars. It can help reduce taxes upon retirement while providing tax-deferred income. 

But that doesn’t mean you can use them to avoid taxes completely. You don’t have to pay taxes as your money accumulates; instead, you will pay taxes when you receive a payout. Withdrawals and lump-sum payments are taxed as ordinary income, not capital gains. The good thing is that it only applies to gains or earnings of non-qualified annuities since taxes are already deducted upon purchase and contribution. 

For example, let’s say you purchase a retirement plan. Once you reach retirement age, you can either take withdrawals or annuitize them. If you choose the former, taxes apply as last-in-first-out (LIFO).

The withdrawal amount is taxed first as the growth element of a non-qualified annuity. However, the extent of taxation is only up to the amount of gains. Once the withdrawn amount exceeds gains, subsequent withdrawals will become tax-free.

Let’s say your $100,000 deposit becomes worth $250,000; you’ve gained $150,000. So, every dollar you withdraw up to $150,000 is taxable. Gains are treated as the last in and are therefore taxed first. 

It is possible to contribute to an annuity without paying taxes on payouts after retirement. You can accomplish this by funding it in a Roth account like a Roth IRA or Roth 401k. However, there are contribution limits to this type of retirement account. 

What Is the Purpose of a Non-Qualified Annuity?

A non-qualified annuity is one of the best tax-deferred investment options for people who have already used up retirement plans offered by their employers. It’s another way to save while generating gains and receiving fixed payouts or a lump-sum value in the long run. 

Often, annuities have two phases, namely, the accumulation and the distribution phase. The accumulation phase refers to the part where you pay premiums while your money grows. You may withdraw funds but face tax or early withdrawal penalties during this phase. Typically, the penalty amount is a specific percentage of the withdrawn amount. 

The distribution phase happens when you receive payouts through self-directed withdrawals or scheduled payments. You have the option to either withdraw the lump-sum value or annuitize it. If you withdraw it, you will receive taxable earnings on top of the principal amount. That way, the principal amount remains intact while generating new earnings.

If you choose annuitization, it will provide you with a fixed income stream after retirement, but you cannot get the lump-sum value of the annuity. Either way, earnings are subject to taxes, but you have more control over your funds. 

When the annuitant dies, the payout schedule and terms may vary. Some plans may allow you to have a beneficiary receive scheduled payments. Some do not have this option, so payouts end upon death. If you choose not to annuitize your fund, your beneficiary will receive a death benefit to the value of your annuity. 

Qualified vs. Non-Qualified Annuity: How Are They Different?

As we discussed above, annuities can be qualified or non-qualified. As with the non-qualified type, individuals can contribute to their qualified annuities while their money increases. Accumulation and distribution phases are present in this type, too.

Additionally, they can get the lump-sum value or annuitize contributions for scheduled payments. But these annuity products have notable differences regarding contribution, distribution, and withdrawal mechanisms. 

First, qualified annuities are purchased and funded with pre-tax dollars, unlike non-qualified ones. Contributions are deducted from the person’s gross income and increase tax-free.

Upon retirement, payouts are subject to taxes. But potential income may be smaller than non-qualified annuities due to contribution limits. Qualified annuities are capped according to the person’s income and whether they have other qualified pension plans. 

With regard to early withdrawals, both types are subject to a penalty, typically 10%, but the extent may vary. Both types set a minimum withdrawal age of 59½, so withdrawals before that age have corresponding penalties.

For non-qualified annuities, only the earnings and interest are typically subject to the penalty. For qualified plans, the entire amount is subject to a tax penalty. 

Once you reach the mandatory withdrawal age of 72, you can withdraw funds or receive a guaranteed income. That applies to qualified annuities, whereas non-qualified annuities do not set a mandatory withdrawal age. Once you withdraw or start receiving payouts, qualified annuities have a different tax treatment. 

Except for a Roth IRA, these are subject to required minimum distribution (RMD) guidelines. The whole distribution amount is taxable for the payouts since the contribution is made using before-tax dollars. Also, if you purchase one to fund a retirement plan or an IRA, you will not have additional tax deferral benefits for that plan. But for a non-qualified annuity, only the earnings are taxable. 

What Are the Different Types of Non-Qualified Annuity?

Before deciding what non-qualified annuity products are best for you, you must first investigate the different options. You may want to get one to cover your living expenses after retirement.

Knowing how much you need and how much return you want to generate is essential. That’s why proper financial planning is so important; the earlier, the better. Talking with a financial advisor may help you become familiar with your options. 

Immediate and Deferred  

Some annuities may start immediately upon the deposit of a lump sum of money. This is referred to as an immediate annuity. It’s the opposite of the typical annuity that has to season for a period of time and accumulate before funds can be withdrawn or annuitized.

Put simply, an immediate annuity is purchased with a single lump-sum payment. It then starts distributing payouts right after you buy it. 

For example, you sell your car and use the proceeds to purchase an immediate annuity. It will provide you with an agreed-upon income scheduled for a specific number of years or as long as you live. However, you cannot invest or spend your purchased annuity in any other way.

Remember that you ensure a specific outcome when you buy immediate annuities, not investing. To be precise, the outcome you will get is income in your retirement years or for the specified period you prefer. 

Annuities can also be structured as deferred benefits. A deferred annuity or deferred income annuity will take time to pay out after the initial payment. Instead, holders choose an age at which they will start receiving payouts. 

This type is more suitable for a retirement account. Since it is a tax-deferred growth annuity, you only pay tax when you withdraw. This is the typical sort as opposed to an immediate annuity. 

Also, a deferred non-qualified annuity has no contribution limits. You can even invest it with an insurance firm and choose among fixed, variable, equity-indexed, and longevity contracts. You will pay income tax on gains once you withdraw. 

Depending on which type you choose, you may or may not recover some portion of the principal invested. It’s more typical in a straight or lifetime payout for there to be no refund. The payments continue as long as the annuitant lives, and there is no death benefit.

There are some options in which annuitants can declare beneficiaries and continue receiving payments once they die. But if the annuity is only for a specific period of time, payouts will last until the period ends. Annuitants or their beneficiaries can withdraw or refund the remaining principal. 

Fixed, Variable and Indexed

Annuities can be structured according to varying levels of risk tolerance. Financial advisors will consider market volatility and your financial position before taking risks. You may prefer to play it safe, but you stand to benefit from higher potential returns if you agree to face more risk. 

A typical example of a safe investment is a fixed annuity. This type has a guaranteed and conservative interest rate set by the insurance company. The fixed option is a perfect fit for low-risk investments. 

On the other hand, a variable annuity is invested in securities like stocks, bonds, and mutual funds, which tend to yield more. The earnings are based on the performance of the securities you select. You may choose either type or a combination of the two. 

Variable annuities are riskier, especially now that market volatility remains high, leading to a bearish trend in the stock and bond market. Therefore, they are more suitable for those with higher risk tolerance. 

If you want better returns than a fixed annuity but wish to avert risks in a variable annuity, consider choosing an equity-indexed annuity. With this type, you may enjoy the best of both worlds. You can realize upside growth based on market performance without negative yields.

This annuity generates credited interest varying with the performance of an equity market benchmark. It includes the S&P 500 and NASDAQ composite indexes. But since it has a 0% floor, some EIA cap gains and fees can eat away a huge chunk of the account value during downtrends in the market benchmark. 

Protect Yourself, Learn More About Non-Qualified Annuity

Having a foolproof retirement plan has become more crucial than ever. You have to ensure adequate financial capacity, especially during economic downturns. Fortunately, a non-qualified annuity promises financial safety. You can generate an income stream to fund your living expenses after retirement while adding an extra layer of protection.

The post What You Need To Know About Non-Qualified Annuities appeared first on Due.



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