What is a nonqualified annuity and how does it work?

There are many types of annuities out there. Critics might say too many types. But if you’re in the market for an annuity, it’s important to understand how they’re described and classified so you know exactly what you’re signing up for and how the product works.

Nonqualified annuities, in reality, are most annuities. You purchase them with after-tax dollars, usually from an insurance company. So a nonqualified annuity can be fixed, variable, immediate or deferred. The term “nonqualified” simply describes the annuity’s tax treatment.

In this article, we’ll dive deeper into the tax implications of nonqualified annuities and how they differ from their qualified counterparts.

What is a nonqualified annuity and how does it work?

A nonqualified annuity is a financial product issued by a life insurance company. You contribute money to the annuity using your after-tax dollars, meaning you’ve already paid taxes on those funds.

Once your money is invested within the annuity, it grows tax-deferred. This means any earnings generated within the annuity, like interest or capital gains, are not taxed until you withdraw the money or start receiving payments.

There are no contribution limits for nonqualified annuities, unlike IRAs or 401(k)s, which impose yearly caps. This flexibility allows high-income earners to save larger sums for retirement.

Unlike qualified annuities, nonqualified annuities don’t have required minimum distributions (RMDs). This means you’re not forced to start withdrawing a certain amount of money from the account starting at age 73, like you are for retirement accounts such as traditional IRAs and 401(k)s.

Tax treatment of nonqualified annuities

You don’t get a tax deduction on the money you contribute to a nonqualified annuity. Since you’ve already paid taxes on those funds, there’s no additional tax benefit on the contribution itself.

However, nonqualified annuities, like all annuities, offer tax-deferred growth.

When you start receiving money from the annuity, the portion of your payment that includes your principal is tax-free, since you already paid taxes on that money when you funded the annuity. However, the portion of the withdrawal comprising investment earnings is considered taxable and is taxed as ordinary income.

Can you withdraw money from a nonqualified annuity?

Yes, you can withdraw money from a nonqualified annuity. However, you’ll likely face early withdrawal penalties and other fees.

If you withdraw money before age 59.5, you’ll face a 10 percent penalty from the IRS on top of any taxes owed. (Remember, withdrawals excluding your original principal amount are taxed as ordinary income.)

There may also be additional surrender charges imposed by the insurance company for early withdrawals. These are usually highest during the first five to seven years of your annuity contract.

Another consideration: Withdrawing a large sum early on can significantly reduce the amount of money available for your future retirement income stream.

Let’s say you initially fund your annuity with $100,000, expecting to receive payments in retirement of $300 a month. But a few years later, you withdraw $30,000 from the account to pay for nursing home care for your mom. You’re going to receive substantially less than $300 a month in retirement from your annuity after that, especially once surrender charges and fees are factored in.

Nonqualified vs. qualified: What’s the difference?

Nonqualified and qualified annuities share some similarities, but their tax treatment is what defines them and sets them apart.

Nonqualified annuities — which to be clear, are most annuities — offer no upfront tax benefit or deduction. These annuities are funded with after-tax dollars, so you don’t receive a deduction on your contributions in the year you make them.

On the other hand, qualified annuities are purchased with pre-tax dollars, usually those from retirement accounts such as a 401(k) or IRA. Qualified annuities are typically part of an existing qualified retirement plan, which could result in a tax deduction for your contribution.

However, you won’t get a double tax break for investing in a qualified annuity through a retirement account. You’re really only benefiting from the tax deduction you would’ve gotten anyway by investing in a traditional IRA or similar account.

Another big difference is how withdrawals are taxed. Nonqualified annuity withdrawals or payments are partially tax-free, partially taxed. You get your original contributions back tax-free, but any earnings accrued within the annuity are taxed as ordinary income.

On the other hand, qualified annuity withdrawals are fully taxable. All the money you receive, including contributions and earnings, is taxed as ordinary income.

Finally, a key difference between qualified and nonqualified annuities is RMDs. With nonqualified annuities, there are generally no RMDs. Money can sit tight all through your retirement. Meanwhile, qualified annuities typically require you to start making minimum withdrawals at age 73, per IRS rules, the same as traditional IRAs and 401(k)s.

Bottom line

Nonqualified annuities are a part of the retirement planning landscape, offering tax-deferred growth and a tax-free return of your initial principle. However, they’re not a one-size-fits-all solution. Carefully consider your tax situation, retirement goals and desired liquidity before making a decision. Consulting a financial advisor or tax professional can help you determine if a nonqualified annuity aligns with your overall financial strategy.