What Are Non-Qualified Annuities?

A non-qualified annuity is an annuity bought with after-tax dollars, whereas a qualified annuity is an annuity bought with pretax dollars, in most cases.

Non-qualified annuities can help reduce your taxable income when you retire and provide tax-deferral on earnings until then. But this type of insurance contract isn’t a good fit for everyone. Learn how it works to see if you should add non-qualified annuities to your financial plan.

Definition and Example of Non-Qualified Annuities

A non-qualified annuity is a long-term retirement savings product entirely funded with after-tax dollars. The money grows tax-deferred, so you won’t have to pay any taxes until you take distributions. At that point, you’re only taxed on your earnings, since you already paid taxes on your contributions.

For example, let’s say you’ve maxed out your 401k and Roth IRA but have more money you’d like to put toward retirement. So you purchase an annuity outside of your employer’s retirement plan and deposit money into it every year. Like your other retirement plans, you’re eligible to make withdrawals without penalty when you turn 59 1/2.

After that age, you can choose to take withdrawals from the annuity or annuitize it and receive payments. If you take withdrawals, you pay taxes on a last-in-first-out basis (LIFO). This means you’ll pay tax on the entire withdrawal up to the amount of your gains. For example, say you deposited $300,000 into an annuity that’s worth $800,000. You’ve gained $500,000. Every dollar you withdraw up to $500,000 will be taxed. The gains are considered the “last in” so are taxed first.

If you annuitize, on the other hand, and receive periodic payments, you’re only taxed on a portion of each distribution because the IRS considers this a return of gains and principal.

The Roth Annuity

There is a way to fund an annuity with after-tax dollars and avoid paying taxes on annuity distributions during retirement. This can be accomplished by contributing to an annuity inside a Roth account, such as a Roth IRA or Roth 401k. A Roth account is subject to contribution limits, but qualified distributions from the account are entirely tax-free because they are made with after-tax dollars.

But since annuities are generally more expensive than other long-term investments such as mutual and index funds, this type of strategy makes the most sense for those who expect to be in a high tax bracket when they retire (and are currently eligible to contribute to a Roth account).

How Non-Qualified Annuities Work

Non-qualified annuities are one way to invest on a tax-deferred basis for people who’ve maxed out their employers’ retirement plans and are looking for additional ways to save. Plus, during retirement, they can provide a guaranteed payment each month if you choose to annuitize. But while annuitization can provide an income stream during retirement, it also means you lose access to the lump-sum value of the annuity.

Most annuities have two distinct phases: the accumulation phase and the distribution phase. The accumulation phase is when you make contributions and your money grows according to how it’s invested. The distribution phase is when you begin receiving distributions, either through self-directed withdrawals or scheduled annuity payments.

If you chose to annuitize, the terms of your payout dictate what happens to the rest of the money once you die (if any). Some types of payouts allow you to name a beneficiary to receive payments, while with others’ payments simply end. If you didn’t annuitize, your named beneficiary or estate will inherit the remaining value of your annuity.

The government doesn’t limit how much you can contribute to your non-qualified annuity. However, your insurance company may place limits on your contributions. Check the details of your contract to see if there are specific rules.

Unlike other retirement options, there’s no mandatory distribution age for non-qualified annuities. However, there usually is a penalty of 10% on the earnings (plus taxes) if you withdraw your funds before you’re 59 1/2.

Types of Non-Qualified Annuities

Here’s a quick overview of some of the different kinds of non-qualified annuities you can buy based on when you’d like to receive payments and your financial risk tolerance.

Immediate and Deferred

When you buy an immediate annuity, you pay a lump sum upfront and start receiving payments soon after. With a deferred annuity, however, your money grows over time before you make withdrawals or annuitize. You can purchase a deferred annuity with contributions made over time or with a lump sum upfront.

Fixed, Variable, and Indexed

Are you in a financial position to take a bit of risk with your money? Do you prefer to play it safe? There are several non-qualified annuities designed for varying levels of risk tolerance.

With a fixed annuity, your annuity has a guaranteed interest rate. The insurance company selects a conservative rate, generally similar to current interest rates. Fixed annuities tend to be a better fit if you prefer low-risk investments.

In contrast, a variable annuity is invested directly in securities such as stocks and bonds, and therefore has the potential to earn more. Its earnings are based on the actual performance of investments you select. Since market conditions can fluctuate, it’s possible to lose money in this type of annuity and it’s better suited for those with higher tolerances for risk.

If you’re looking for a better rate than what a fixed annuity provides, but are not comfortable with the market-based risk involved in a variable annuity, you may be interested in an equity-indexed annuity. This type seeks the best of both worlds: upside growth according to market performance without the downside risk of negative returns.

Equity-indexed annuities (EIAs) are credited interest according to how a market benchmark such as the S&P 500 performs, but typically have at least a 0% floor. In other words, an EIA will not lose money based on market performance. That said, some EIAs cap gains, and fees can eat away at the account value when the benchmark performs poorly.

Non-Qualified Annuities vs. Qualified Annuities

In some ways, qualified and non-qualified annuities are similar. With both, you’ll get hit with a penalty if you make an early withdrawal. They also both provide the benefit of tax-deferred investment earnings—you don’t pay taxes until you withdraw the funds.

However, there are important differences between them. You use after-tax dollars to pay for non-qualified annuities and, generally, pretax dollars for qualified annuities. Since you’ve already paid taxes on your contributions with a non-qualified annuity, you’re only taxed on earnings when you withdraw them. Conversely, you’re taxed on both contributions and earnings when you withdraw money from a qualified annuity.