How Qualified and Nonqualified Fixed Annuities Differ 

by Shane Flait, ©2008

An annuity is an investment contract. Three aspects of an annuity are:

1.      accumulation phase: you contribute money to it;

2.      contribution earnings: contributions earn income within the contract;

3.      annuitization phase: at some point you choose a payout option and begin receiving payouts

An annuity is qualified if it is part of a qualified plan associated with your employment. Qualified plans are government regulated plans geared to help you save for retirement through tax incentives.  The characteristic of qualified plan annuities are

1.      Yearly contributions to it are:

·         limited and based on the type of qualified plan

·         tax deductible from your employment income.

2.      Contribution earnings grow

·         Tax-deferred

3.      Payout during the annuitization phase

·         All taxed at your ordinary income tax rate

·         Minimum required distributions must begin after you turn 70½

1.      Early withdrawals – before age 59½  - are

·         Penalized at 10% of withdrawal as well as taxed as ordinary income

·         exceptions from penalty for disability, essentially equal payments over life,

Nonqualified plans do not have all these characteristics. Most annuities are not in qualified plans and therefore are nonqualified annuities. But they’re tax-advantaged because their earnings grow tax-deferred. So they share characteristic 2 about contribution earnings. They also share the early withdrawal penalties and the exceptions.

Nonqualified annuities differ from their qualified counterparts because their

·         Yearly contributions are not tax-deductible from working income. In fact they can come from any source – gifts, inheritance, previous savings.

·         Payout is taxed only to the extent of contribution earnings. The principal or tax basis (i.e. contributions) is returned tax-free. Every payout is considered part earnings and part return of principal. You annuity company can tell you what the tax exclusion ratio of each payout is.

See the table for a summary of the comparisons.

Shane Flait is a writer and educator. Get more info at www.EasyRetirementKnowHow.com