Annuities are tax-advantaged insurance contracts in which you can save for retirement and from which you can receive a stream of guaranteed income. Qualified annuities are annuities you purchase with pre-tax dollars in an employment retirement plan, such as a 401(k) or a 403(b).
While qualified annuities are a solid investment option for some people, they aren’t a good choice for everyone. Learn more about this insurance product so you can decide if it’s right for you.
Definition and Examples of Qualified Annuities
Annuities are insurance products that come in two general flavors: deferred and immediate. Deferred annuities are tax-advantaged accounts that can help you build wealth over a period of years, often decades. Immediate annuities are designed to pay out a stream of guaranteed income shortly after purchase that is based on your life expectancy.
Deferred annuities are generally found in retirement accounts. If a deferred annuity is in a 401(k), for example, it’s also a qualified annuity. Deferred annuities allow you to grow contributions on a tax-deferred basis until you receive them during retirement.
An annuity you purchase outside of a retirement plan is called a nonqualified annuity, while an annuity you purchase within such a plan is a qualified annuity. Both offer tax-advantaged growth, but annuities in a qualified retirement account can be purchased with pre-tax dollars. This means you don’t pay any taxes on contributions. Your money continues to grow tax-free as long as it stays in the account. However, when you begin withdrawing funds, all of your distributions are taxed.
A qualified annuity is subject to additional limits, such as contribution limits, that the IRS places on qualified retirement accounts.
Withdrawals from an annuity held within a Roth retirement plan, such as a Roth 401(k) or Roth 403(b), are not subject to income tax if withdrawals are made after age 59 ½.
In addition to offering tax-advantaged growth, annuities are designed to provide you with a steady stream of guaranteed income for life—or for a specified number of years—through a process called annuitization. When you’re ready to start receiving income from the contract, you can choose to annuitize or make withdrawals (without annuitizing).
- Alternate name: Tax-qualified annuity
How Qualified Annuities Work
Qualified annuities can help you save money for your retirement years and generate an income stream once you stop working. There are two phases to these types of annuities: the accumulation phase and the distribution phase:
- Accumulation phase: During the accumulation phase, your contributions may be invested or credited at a fixed interest rate depending on the type of annuity you have. Annuities in which you invest contributions are called variable annuities. Those in which contributions are credited at a fixed rate are called fixed annuities.
- Distribution phase: The other phase of a qualified annuity is the distribution phase. This is when you start receiving payments or taking withdrawals. You can choose to annuitize the contract and receive payments for the rest of your life or a set number of years. If you annuitize, you no longer have access to the contract value, which is why some choose withdrawals instead. In either case, you’ll pay income tax on the amount you receive.
If you withdraw funds from an annuity before you turn 59 ½, you may owe a 10% early withdrawal penalty plus income taxes on the amount withdrawn. This applies whether the annuity is qualified or not.
If you annuitize your contract, your beneficiary may not receive any payments once you die unless you choose certain payout options, such as “life with term certain.” If you don’t annuitize, your assets will pass to the named beneficiary on the contract.
Types of Annuities
Whether you’re buying a qualified or non-qualified annuity, you have two categories to choose from:
- Immediate annuity: You can convert a lump-sum payment into an income stream right away, also known as a single premium immediate annuity (SPIA). You could be subject to the early withdrawal penalty if you use a SPIA before turning 59 ½.
- Deferred annuity: You can let your money grow over time. With these, you won’t start getting payments until some time in the future, typically once you reach retirement age.
There are also several types of annuities available, including:
- Fixed annuities: These products are low risk, but they also offer less potential for growth and less potential to outpace inflation. Fixed annuities earn a guaranteed interest rate that never dips below a contractual minimum.
- Variable annuities: Variable annuities are riskier than fixed annuities, but there’s also potential to earn more. Because performance depends on the value of stock market investments, you could also lose the money you’ve invested (just like you could with money invested in stocks outside an annuity). These products tend to be more expensive than other types of annuities.
- Indexed annuities: Indexed annuities are more complex and combine characteristics of fixed and variable annuities. They have a minimum guaranteed interest rate plus a market-dependent interest rate. Though you can’t lose money in the market with these products, you may not make enough to outpace inflation. You could earn less than you would make in a fixed annuity.
Types of Qualified Annuity Payout Options
There are several types of payout options with a qualified annuity. You would choose a payout option if you decide to annuitize the contract during retirement (instead of taking withdrawals). Keep in mind that when you annuitize, you generally give up access to the contract value.
Here’s a look at three common payout options.
- Life payout: You will receive payments until you die. These payments don’t transfer to your heirs.
- Life with period certain payout: You receive payments for at least a specified period of time or for your entire life (whichever is longer). If you die before the designated period expires, your beneficiary can receive payments until the period is over.
- Joint-and-survivor payout: Two people can receive payments for as long as at least one of them is alive. Once the first person dies, the other receives a set percentage of the payout amount until the end of their life.
Because annuities offer so many options and features, consider speaking with a fee-only financial advisor to see which ones would be best for you.
Qualified Annuities vs. Non-Qualified Annuities
|Qualified Annuity||Non-Qualified Annuity|
|Contributions||Made with pre-tax income (except for Roth plans)||Made with after-tax income|
|Taxes on withdrawals||Yes (except for Roth plans)||Only on the gains portion of withdrawals or payments|
|Annual purchase caps||Yes—determined annually by IRS||No|
The difference between qualified and non-qualified annuities is the type of money you use to pay your premiums. If you use pre-tax dollars, it’s generally a qualified annuity, except in the case of Roth-type accounts. If you don’t use pre-tax dollars, the annuity is non-qualified.
Taxes on Withdrawals
If you use pre-tax dollars to pay for your qualified annuity, you won’t be taxed on the income you contribute to the annuity for the year you make it. However, you have to pay income tax on all of your distributions once you start taking money from the annuity.
If you use post-tax dollars to pay for your non-qualified annuity, you have to report the money as income to the IRS the year you pay it. But when you receive payment, you’ll only have to pay taxes on the growth, not the principal. And if the annuity is in a Roth account, like a Roth 403(b), you can receive the entire amount tax-free.
Annual Purchase Caps
The IRS limits how much money you can contribute to pre-tax accounts like traditional IRAs and 401(k)s. There are no such IRS limits on non-qualified annuities.
- Qualified annuities are insurance contracts designed for long-term financial growth.
- Generally, you pay for qualified annuity premiums with pre-tax dollars. The money then grows tax-deferred, and you pay income taxes on it when the funds come out.
- There are many different kinds of qualified annuities. You can select from different options and features depending on your financial situation and long-term goals.
- You can choose to annuitize an annuity once you’re ready to receive income from it. You may also take withdrawals without annuitizing the contract.