As with a non-qualified, a qualified annuity can provide a guaranteed income for retirement. Moreover, your long-term investment can grow tax-deferred. However, because qualified annuities are purchased with pre-tax funds, this will alter how contributions and withdrawals are taxed.
What is a Qualified Annuity?
As previously mentioned, a qualified annuity is funded by pre-tax dollars. If you recall, non-qualified annuities are funded with post-tax dollars. Another key difference is that you may have the ability to invest in a qualified annuity via your employer’s retirement plan or a traditional IRA.
Contributions to a qualified annuity are dependent on your income. Therefore, you must also follow the required minimum distribution rules that are also applied to traditional 401(k)s and IRAs. This means that you must begin taking minimum distributions starting at the age of 70 ½.
Understanding a Qualified Annuity
“A deposit into a qualified annuity is made without taxes being withheld,” writes Julia Kagan for Investopedia. Consequently, this will reduce “the taxpayer’s income, and taxes owed, for that year. In addition, no taxes will be owed on the money that accrues in the qualified account year after year as long as no withdrawals are made.”
“Taxes on both the investor’s contribution and the investment gains that have accrued will be owed after the investor retires and begins taking an annuity or any withdrawal from the account,” adds Kagan.
“While distributions from a qualified annuity are taxed as ordinary income, distributions from a non-qualified annuity are not subject to any income tax on the contributions,” she states. “Taxes may be owed on the investment gains, which generally are a smaller portion of the account.”
Overall, a qualified annuity presents more immediate tax savings. And, there’s also “a smaller hit on take-home pay during the person’s working years.”
Advantages and Disadvantages of a Qualified Annuity
The primary advantage of a qualified annuity is the tax-deductible premiums. To put that another way, this is the ability to pay premiums with pre-tax dollars. Why’s that important? Because this allows you to fund the annuity without worrying about taxes.
Also, like with a non-qualified annuity, there’s tax-deferred growth. And premium payments are deductible.
There are some other criticisms with qualified annuities, however. Namely, there are penalties for early withdrawals. Additionally, individuals must have an earned income and there are contribution limits. Moreover, retirement plans offered through your employer will have different tax rules and the amount you can contribute.
Qualified Annuity Withdrawal and Taxes
We can’t stress this enough. Money in both qualified and non-qualified accounts will accumulate tax-deferred until it’s withdrawn. Untaxed portions of any withdrawals will increase your earnings for the year. And that has the potential to increase your income into a higher tax bracket.
Also, because qualified accounts are entirely tax-deductible contributions, every dollar you withdraw is taxable. But, that’s not the case with non-qualified retirement accounts where only growth is taxable. As of 2021, the contribution limits for a traditional IRA are $6,000 and a $1,000 catch-up contribution if you’re over 50.
What happens when distributions from these accounts exhaust their earnings? Well, any subsequent withdrawals will be considered a return of your deposits. Also, don’t forget that if you make distributions before the age of 59 ½, with both account types, it could lead to early withdrawal penalties. Another difference is that money in a non-qualified retirement account can remain there for an indefinite period of time. But, with a qualified annuity, you must begin withdrawing assets by age 70 1/2.
What about deductibility? Deposits into qualified accounts result in an income tax deduction. This will be for the year in which the contribution was made. Note that this deduction may reduce your taxable income significantly enough that it could drop you into a lower tax bracket.
Qualified Annuity FAQs
What do you purchase qualified funds with?
Short answer? Pre-tax funds.
Often, this comes from pre-tax retirement accounts that you or your employer either sets up. Since taxes aren’t paid until you begin withdrawing from the account, these are called “tax-deferred” accounts. The may point behind these accounts is that you will be placed in a lower income tax bracket in retirement. In turn, this will help you enjoy more favorable tax rates throughout retirement.
Common pre-tax accounts, according to the IRS, include;
- Traditional IRAs
- 401(k) plans
- Profit-sharing accounts
- 457 plans 403(b) plans
Because you haven’t been taxed on the money you deposit, it’s called “pre-tax.” Additionally, within a pre-tax account, you can choose from various types of investments, such as CDs, mutual funds, stocks, bonds, and of course, annuities (fixed, variable, or immediate).
Is there an annual cap on purchase?
Yes. The IRS limits how much of your income you may invest annually.
Are there distribution requirements?
You must begin withdrawing funds by age 70 ½.
How are distributions from accumulation annuities taxed?
For qualified annuities, “the tax rules for qualified plans and IRAs trump the rules for the annuity,” writes Daniel Schorn for Northwestern Mutual. “If all contributions were made pre-tax, as they usually are in this context, then you will owe ordinary income tax on any withdrawal or distribution.”
How do distribution and transfers work with a qualified annuity?
You’re required for both qualified and non-qualified annuities to be 59 ½ before withdrawing any funds. If you withdraw the money before that age, the IRS will impose a 10-percent tax penalty on your earnings. There are exceptions for annuity holders who become either disabled or die.
Federal law also requires qualified annuity owners to start taking distributions at the age of 70 ½. But, there are no such requirements for when withdrawal begins from non-qualified annuities on the federal level. However, some state laws may set requirements.
What’s more, with qualified annuities, transfers are permitted. But, the transfers are limited to funds in the annuity that is considered tax-deferred. So, why would you make a transfer? Well, you may want to switch to an annuity with a higher interest rate, or that has more favorable riders, such as an enhanced death benefit or guaranteed minimum income. Other reasons could be that if you have a variable annuity, another product has better investment options. Or, maybe, the annuity company isn’t financially strong.
Is a qualified annuity right for you?
If you anticipate being in a lower tax bracket when you retire because you can defer taxes on contributions and earnings, then a qualified annuity may be worth considering. And, in addition to providing a guaranteed lifetime income, a qualified annuity can let you name a beneficiary.