An annuity is a contract between you and an insurance company that guarantees a stream of income, often for life, in return for a lump-sum payment or a series of payments over time.
Unlike qualified annuities, which you can fund with pre-tax dollars usually held in a retirement plan like 401(k) or an individual retirement annuity (IRA), non-qualified annuities are purchased with money that's already been taxed. You won’t have to pay taxes on your initial investment again when you start collecting income payments.
And because non-qualified annuities don’t have contribution limits, they can help you complement your investment portfolio and prepare for retirement.
People who can benefit the most from non-qualified annuities are high earners who’re already maxing out contributions to any qualified plans available to them.
What is a non-qualified annuity?
A non-qualified annuity is a retirement savings plan with a unique feature: its lack of tax-exempt status. Unlike a qualified annuity, which can be funded with pre-tax dollars, a non-qualified annuity must be purchased with money that’s already been taxed. Qualified annuities are usually held in 401(k) or 403(b) plans — although they can also be held in IRAs.
Also, unlike a qualified annuity, employers generally don’t sponsor non-qualified plans. If you want to set up a non-qualified annuity, you’ll have to do that on your own through a life insurance company.
Learn more about other types of annuities
How do non-qualified annuities work?
With a non-qualified annuity, you’ll make payments with income or other money that’s already been taxed. Once you reach age 59½, you can start withdrawing from this fund without having to pay a penalty fee. You won’t have to pay additional taxes on the principal that you paid, but you’ll be taxed on any growth that’s accumulated. [1]
With a non-qualified annuity, there’s no limit to how much money you can invest. You also don’t need to withdraw money when you reach a certain age, like you have to with a qualified annuity.
How do non-qualified annuities get funded?
You can fund a non-qualified annuity any way you like, including your income, savings, an inheritance, gifts, or the sale of an asset. The only thing you can’t fund a non-qualified annuity with is your pre-tax income.
What types of accounts can hold non-qualified annuities?
Non-qualified annuities are most commonly housed in Roth IRAs, but they can also be held in mutual funds, certificates of deposit, and savings accounts.
Once you set up the account, you can set up an annuity within it to manage your money as you like.
Depending on how you want to invest your funds, your non-qualified annuity contract can be fixed, variable, or indexed.
If you want to start receiving payments right away, you can opt for a non-qualified immediate annuity. If you’d rather start withdrawing money in the future, you can buy a non-qualified deferred annuity instead.
Do non-qualified annuities have contribution limits?
No, non-qualified annuities don’t have contribution limits, which is one of their most attractive features. You can put as much money as you choose to into a non-qualified annuity.
If you’re already maximizing contributions to any qualified annuities you may have and want to invest additional after-tax dollars toward retirement, adding a non-qualified annuity contract to your investment portfolio can help.
How are contributions taxed in a non-qualified annuity?
Since the money you put into a non-qualified annuity has already been taxed, you won’t have to pay taxes on the principal when you start withdrawing from the account. However, any growth you receive from the annuity will be taxed as income. [2]
Do non-qualified annuities have distribution requirements?
The only distribution requirement for a non-qualified annuity is that you can’t withdraw funds until you reach age 59½ without incurring a 10% penalty. But after that, you can choose to withdraw or not withdraw funds as you see fit.
There are no required minimum distribution (RMD) requirements on a non-qualified annuity like there are on a qualified annuity. You can keep the money in your account for as long as you choose to.
How are distributions taxed in a non-qualified annuity?
When you withdraw money from a non-qualified annuity plan, you won’t have to pay taxes on the principal you paid — that money’s already been taxed. However, you’ll have to pay taxes on any growth the annuity has accumulated.
What are the pros & cons of non-qualified annuities?
Non-qualified annuities can be a useful investment tool, but they’re not for everyone. Consider the pros and cons of a non-qualified plan before setting one up.
Pros
No contribution limits. With a non-qualified annuity, you can put as much money as you choose into your account. With a qualified annuity, you’ll have an annual limit imposed by the IRS on how much you can deposit.
Not required minimum distribution. Qualified plans force you to start withdrawing money by age 72 (or age 73 if you reach age 72 after Dec. 31, 2022), otherwise you ’ll be subject to additional fees. [3] With a non-qualified annuity, you can leave the money in your account for as long as you like. You don’t have to withdraw it until you want to.
Cons
No tax benefits. You won’t be able to reduce the amount of your taxable income with a non-qualified annuity like you’d be able to with a qualified annuity.
Subject to surrender charges and other fees. If you do need to withdraw funds from your annuity before age 59½, you could face significant surrender charges.
What should you consider before buying a non-qualified annuity?
Before you purchase a non-qualified annuity, make sure you’ve considered your other investment options. For most people, the tax-deferred option included in a qualified annuity can be more advantageous.
Who should consider non-qualified annuities?
Non-qualified annuities are best for people who’ve already maximized their investments in 401(k)s and IRAs and are willing to give up some liquidity to make a long-term financial investment.
“Also, annuities can trigger penalties if funds are withdrawn before age 59½, similar to retirement accounts,” says Zachary Bachner, certified financial planner at Summit Financial Consulting, LLC. “This means there is an aspect of flexibility that is sacrificed for the annuity, so these are only meant for long-term savings, especially due to the surrender schedules on the products.”
If you’re unsure whether or not a non-qualified annuity will fit into your retirement planning, speak with a financial advisor you can trust who can help you choose the right type of annuity or investment option for you.
