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.
Qualified annuities are funded with pre-tax dollars that are usually held in retirement accounts like a 401(k) plan or an individual retirement annuity (IRA). You won't pay taxes on any of the funds in a qualified annuity until the payout phase, when your income payments will be taxed as earnings.
Since qualified annuities are tax-advantaged accounts, you won't be able to take any money out before age 59½ without paying a 10% penalty on any funds you withdraw early. People usually set up qualified annuities through their employer, or their IRAs, to create an income stream during their retirement years.
What is a qualified annuity?
A qualified annuity is an insurance contract held in a tax-advantaged retirement savings plan. You contribute money from your employee retirement account or IRA, and in return, you'll receive a stream of income payments after you retire that can last for a set period of time, a specific amount of money, or the rest of your life.
Since you can only pay for a qualified annuity with your earnings, these plans are often set up in conjunction with your employer, such as with a 401(k) or 403(b) plan.
You can withdraw money from a qualified annuity starting at age 59 ½ without having to pay penalty fees. When you do begin receiving income payments, you'll be taxed on both the money you funded the annuity with, and any interest it earned, as a percentage deducted from each income payment. Additionally, you must start withdrawing from a qualified annuity no later than age 73.
However, you'll be taxed at the income tax bracket you qualify for at the time of withdrawal, not at the time you earned the funds. This means that if you expect your retirement income to be less than the income you earn while you're working, a qualified annuity will likely be beneficial for you, because you'll keep more of your money.
Learn more about other types of annuities
How do qualified annuities work?
Since the IRS has approved qualified annuities for use as a retirement plan, you fund the annuity with pre-tax dollars from your earnings. This money will grow over time at an interest rate based on the type of contract you choose — fixed, indexed, or variable — and you'll be able to start making withdrawals once you reach age 59 ½. The money won't be taxed until you start receiving income payments in retirement.
How do qualified annuities get funded?
“Qualified annuities must be paid for with earned income,” says Tony Boyden, learning and development partner at Zinnia. People often regularly contribute a portion of their paycheck to their qualified annuity plan through an employer-sponsored plan like a 401(k) or 403(b). But you can also fund a qualified annuity through an IRA.
What types of accounts can hold qualified annuities?
Qualified annuities are commonly held in defined benefit plans, 401(k)s and 403(b)s, or an individual retirement account (IRA). These accounts will invest your money in stocks, bonds, mutual funds, or annuities. "Annuities can be used as the investment option inside any of these qualified options," says Daniel J. Galli, certified financial planner at Daniel J. Galli & Associates.
Do qualified annuities have contribution limits?
Yes, there’s a limit to how much you can contribute to a qualified annuity every year. For example, with a 401(k), the IRS will currently only let you contribute $23,000 per year if you’re under age 50, or $30,500 if you’re 50 years old or older. [1] For an IRA, the limit is $7,500 per year if you’re over 50 years old and $6,500 if you’re younger. [2]
How are contributions taxed in a qualified annuity?
Your contributions to a qualified annuity aren't taxed, and thus don't count toward your taxable income when tax season rolls around. You'll only pay taxes on your withdrawals after you retire, when each income payment will be taxed like ordinary income.
Do qualified annuities have distribution requirements?
If you purchase a qualified annuity, you have to start withdrawing from it no later than age 72 (or age 73 if you reach age 72 after Dec. 31, 2022). When you reach this age, your annuity will have a Required Minimum Distribution (RDM). If you don't withdraw the money you're required to, it could be taxed at 25% of the required amount. [3]
How are distributions taxed in a qualified annuity?
When you start receiving income payments in retirement, those payments will be taxed as income. Each year, your total income will qualify you for a certain tax bracket, and you'll pay income taxes accordingly. If you earned a salary that was higher or lower than what you'll collect from the annuity, it won't matter: Your income tax amount will be determined based on each year you receive income payments after you retire.
What are the pros & cons of qualified annuities?
Qualified annuities can be a great way to minimize your taxable income now in order to maximize your income in retirement, all while taking advantage of employer benefits. But you'll also need to consider contribution limits and required minimum distributions (RMDs) to get the most out of your annuity.
Pros
Tax deductions. You can deduct the money you contribute to your qualified annuity from your total taxable income.
Employer benefits. Many qualified annuity plans come with employer benefits, such as a 401(k) contribution match.
Cons
Contribution limits. There’s a limit to how much you can invest in a qualified annuity every year, so using a qualified annuity on its own may not be sufficient to fund your financial goals for retirement. However, you can complement it with a non-qualified annuity, which you can fund with after-tax dollars.
Required minimum distributions (RMDs). You can’t hold onto your qualified annuity forever; when you turn 73, you’ll have to withdraw a minimum amount specified in your contract or face penalties.
What should you consider before buying a qualified annuity?
One of the main considerations before choosing a qualified annuity is determining whether it's better for you to defer more of your paycheck for the future, or to collect it as you’re paid. Generally speaking, if you’re earning an income, whatever you can afford to invest in a qualified annuity via a 401(k) or IRA will be in your best interest. But determining the right amount will come down to your budget and savings goals.
Who should consider qualified annuities?
If you’re earning an income and can afford to invest some of it for future gains during your retirement, you should consider a qualified annuity, since its tax-deferred structure is advantageous to most people.
If you’re unsure whether or not a 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.
