What Is a Qualified Annuity?
A qualified annuity is a financial product that accepts and grows funds and is funded with pre-tax dollars. "Qualified" is a descriptor given by the Internal Revenue Service (IRS) to indicate that the annuity may be eligible for a tax deduction. Only when a distribution or withdrawal is made is a qualified annuity subject to income tax (as ordinary income).
What Is An Annuity?
A qualified annuity differs from a non-qualified annuity, which is an annuity funded with after-tax dollars. Deposits into qualified annuities (usually pre-tax dollars) result in an income tax deduction. Other than that, qualified and non-qualified annuities work in the same way. While distributions from a qualified annuity are taxed as ordinary income, distributions from a non-qualified annuity are not subject to income tax in their entirety. Qualified annuities are often set up by employers on behalf of their employees as part of a qualified retirement plan, such as a defined benefit plan, a 403(b) retirement plan, or an individual retirement account (IRA). An annuity becomes qualified when it meets certain IRS criteria and follows regulatory guidelines. Generally, any annuity that is not used to fund a tax-advantaged retirement plan or IRA is a non-qualified annuity.
Qualified Annuity vs. Non-Qualified Annuity
The best way to define a qualified annuity is to compare it to a non-qualified one. The biggest difference is that qualified annuities are funded with pre-tax money, while non-qualified annuities are purchased with after-tax money. With a non-qualified annuity, the lion's share of a payment is a return of principal, which is not taxed, while a smaller portion is investment income, which is taxed at ordinary income rates rather than the capital gains rate. Some other features of non-qualified annuities include:
- Non-qualified annuities are tax-deferred and grow tax-free until a withdrawal is made or it is annuitized.
- Non-qualified annuities do not provide a step-up in cost basis at the annuity owner's death; deferred earnings will be taxable as ordinary income to a beneficiary that is not a spouse.
- A surviving spouse may continue a policy to preserve tax-deferred growth.
- Annuities are considered as part of an estate for tax purposes.
Non-qualified annuities purchased after August 13, 1982, are taxed under a last in, first out (LIFO) protocol. This means that the first withdrawals will be made from accrued interest, which will be taxed as ordinary income. Once that interest has been fully taxed, the remaining principal/premium will be distributed tax free.
Rules governing qualified annuities are covered in IRS Publication 575, Pension and Annuity Income.