Qualified versus Nonqualified Annuities – Which Suits You?

5 Sep

Qualified deferred annuities carry significantly different contribution, withdrawal, and tax regulations compared to non-qualified deferred annuities. Know these differences to choose which type you should use.

Annuity

Nonqualified

Qualified

Tax-deferred earnings

Yes

Yes

Early withdrawal penalty (10% IRS)

Yes

Yes

Contribute with

pre-tax dollars

No

Yes

Contribution based on ‘work’ earnings

No

yes

Yearly contribution limits

No

Yes

Accept direct rollover from qualified plan

No

Yes

Withdrawal requirements

No, or much later

MRD at 70½

An deferred annuity is a contract you make with an insurance company to grow your principal and then if you choose, to receive as series of payments–usually for life –in return for your ‘premium’ contributions. You can purchase either a fixed deferred annuity or a variable deferred annuity.

An deferred annuity has two phases: accumulation and annuitization. During the accumulation phase, you contribute premiums that are invested for growth. You receive your series of payments during the annuitization phase (you may also choose to make your withdraw in a lump sum).

Nonqualified Deferred Annuities
Earnings within a deferred annuity–like those of a life insurance contract–are not taxed as long as they stay in the deferred annuity.  Taxes on these earnings are deferred until they are withdrawn. But if you withdraw any earnings before 59½, the IRS imposes a 10% penalty–in addition to any other income tax and contract fees that may be imposed.

Contributions during the accumulation phase are unrestricted. You can pay in equal payments, an immediate one-time payment, or any other amount you wish. There are no limits but all contributions are made with after tax money.  You could begin your annuitization payments as late as you like. Many insurance companies may require you to begin at 85, but that is up to the contract. You pay tax only on the earning’s portion of each payment.

Qualified Deferred Annuities
Qualified annuities are regulated by the same tax benefits and restrictions of other qualified plans like IRAs.   The table above compares nonqualified to qualified annuities.

The main additional benefit of a qualified deferred annuity over a nonqualified annuity is the use of pre-tax contributions.  However, yearly contributions are limited. For 2008, it is $5,000 ($6,000 if you are 50 or older) with a phase out of the deductibility at high incomes if you have a qualified plan at work.
Also IRS regulations force annuitization to begin in the year you turn 70½ with payouts that satisfy the minimum required distribution (MRD) of qualified plans.  The full payout of a qualified deferred annuity is taxed as ordinary income since only pre-tax contributions funded it.

Transfers or Rollouts into Qualified or Nonqualified Annuities
You can use a qualified deferred annuity to receive a rollout of an IRA or 401 (k), or other ‘pre-tax’ retirement plan.  You would only use an nonqualified annuity if you had first paid taxes on funds you rolled out of such a plan.

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