Qualified Annuity

What is a Qualified Annuity?

A qualified annuity refers to a retirement savings plan that is funded with pre-tax dollars, with tax-deferred features, and is approved by the Internal Revenue Service (IRS). IRS insists that all qualified plans must satisfy the Internal Revenue Code in form and operation. All funds deposited into a qualified annuity must be earned income.

A qualified annuity is distinguished from a non-qualified annuity, which is funded by post-tax dollars. Qualified annuities are usually funds from an IRA or a 401(k). They receive contributions through deductions from investor’s gross earnings.

A qualified annuity also receives investments and is allowed to grow tax-deferred. It requires that all earnings on the investment are not taxed or subjected to federal taxes until after retirement, when distributions/withdrawals are paid out to the investor.

Qualified annuity premiums may be tax-deductible. All rules and regulations of qualified annuities are detailed in IRS Publication 575: Pension and Annuity Income. Annuities, qualified and non-qualified, are usually sold by brokerage firms and insurance companies.

Understanding Qualified Annuities

A qualified annuity is part of a tax-deferred retirement plan. All funds paid into the annuity fund are tax-deductible during the contribution or accumulation phase. However, during the annuitization phase, when annuity payouts are made, they will be taxable as tax will not have been paid yet.

A retirement plan with deferred tax payment benefit comes in handy after retirement when an investor’s federal tax bracket will be lower than the contribution or working phase. A qualified annuity is also beneficial with inheritance and guaranteed pay-outs plans. IRAs have built-in tax deferral capabilities, which makes them unnecessary to be used for tax purposes.

There are also qualified annuity contribution limits depending on the type of plan adopted by an investor. In addition, employers can adopt different tax rules and contribution thresholds between employer and employee.

A qualified plan ensures that no taxes are owed each year, just as long as there are no withdrawals from the annuity account during the year. The opposite is true for non-qualified annuity withdrawals, which are not subject to federal income tax.

Taxes are only owed on investment gains, which are, at the very least, inconsequential to the size of the account. Investors choose what works best for them between a qualified annuity plan with tax deferral advantages at the contribution phase or a non-qualified annuity plan providing tax-free income after retirement.

Retirement Annuities

To understand qualified annuities better, it is important to define an annuity in the context of a retirement plan. An annuity is a financial arrangement offered by a financial company/insurance company. It enables investors or employees to contribute several scheduled contribution payments over a defined period during their productive life in exchange for the receipt of pay-outs from that company after retirement.

The payments are made either until the annuity holder’s death or until the funds in the plan are exhausted. Other annuities allow for a defined period during which pay-outs will be made after retirement, and others further allow the annuity holder’s beneficiaries to inherit the plan after death.

Several types of retirement annuities differ in terms of taxation, investment returns, and fees payable. Therefore, it is prudent to select annuity plans carefully through ample discussions with your financial or legal advisor. It is also important to conduct some research on the financial company offering annuity plans.

Retirees’ Payout Structures

Retirees can choose among several pay-out structures, including:

• A lump sum pay-out
• A lifetime annuitized income stream
• An annuitized income stream for a specified period

Types of Qualified Annuity Plans

Companies usually establish qualified annuity plans as part of a company-sponsored retirement plan for their employees. They include the following types:

• Defined Benefit Plan – A savings plan that involves the company committing to a specific payment schedule which is either in regular installments or paid as a lump sum based on employee earnings history.
• 401(k) – A plan set up by a company to reward its employees. It is facilitated through the SECURE Act of 2019, making it easier for annuities to be included in 401(k) plans.
• 403 (b) – A plan available to tax-exempt organizations and principally includes teachers and public service employees.
• Individual Retirement Annuity (IRA) – An IRA is a savings plan that allows for pre-tax contributions up to an annual limit. They include SEP-IRA plans and SIMPLE IRA plans. IRA annuity holders are limited to contribute $5,500 per year or $6,500 for people older than 50 years, except for rollovers.
• SARSEP Plan – Established before 1997, SARSEP is a simplified employee pension plan (SEP). It includes a salary deduction arrangement where employees let the employer contribute a portion of their salary to the Individual Retirement Annuity (IRA) set-up under SEP-IRA.
• Tax Sheltered Annuity (TSA) – A TSA allows for increased flexibility on contribution amount, which is impossible with most plans. A TSA annuity holder is allowed to contribute all the years that he/she was unable to contribute. It is a popular plan with teachers and health care workers.

Different plans change the effect of taxes on withdrawals and distributions from the annuity. Legal ramifications are also different in various instances.

Qualified Annuity vs. Non-Qualified Annuity

A qualified annuity is funded or purchased through pre-tax dollars, and a non-qualified annuity is funded through after-tax dollars.

• Qualified annuities come with a limit placed on the amount of income invested per year, while a non-qualified annuity is not subject to a cap or limit. The limits are determined by an investor’s income level during their working period or whether they participate in other qualified retirement plans.
• Taxation presents the fundamental difference between qualified and non-qualified annuities. Contributions in a qualified annuity are tax-deferred, but contributions in a non-qualified annuity do not receive any special treatment as funds are taxed as normal.
• Qualified annuity withdrawals and pay-outs are taxed as regular income, i.e., at the holder’s income tax bracket. On the other hand, only the earnings proportion of withdrawals from a non-qualified annuity is taxed, but the principal is not taxable.

The IRS uses an exclusion ratio (based on the principal, length of the annuity, and earnings) to determine a non-qualified annuity taxable withdrawal portion. The exclusion ratio considers life expectancy to spread principal and earnings over the investor’s lifetime, and any payments beyond the life expectancy are taxed as income.

• Qualified annuity holders can transfer funds between different types of annuities (i.e., fixed and variable), but the transfers are restricted to only tax-deferred funds in the annuity. Non-qualified annuity holders can also transfer funds between different types of annuities without attracting the federal early withdrawal penalty due to the 1035 Exchanges regulation of the Internal Revenue Code.
• The last comparison is the distribution requirement, where qualified annuity holders can begin to withdraw their funds by the age of 70½. Still, non-qualified annuity holders are not subject to any requirement when withdrawing their funds, which can be distributed anytime. The minimum age for making withdrawals on both annuities is 59½.

The IRS imposes a 10% tax penalty on earnings if funds are withdrawn before 59½ for both annuities. Exceptions are, however, made for disabled annuity holders and individuals who pass away. Qualified annuity holders can face an additional penalty if they skip scheduled minimum distributions (RDMs), resulting in a 50% penalty on the required withdrawals.

Benefits of a Qualified Annuity

Choosing the best annuity plan that suits individual requirements should be done meticulously as considerations need to be made over tax status, retirement needs, and overall financial goals. It is, therefore, worthwhile to indicate the benefits of qualified annuities to assist decisions by potentially qualified annuity holders.

• The major advantage of qualified annuities is the tax-deductible premiums, i.e., the ability to pay premiums with pre-tax dollars.
• The ability to pay premiums with pre-tax dollars means that funds used for the annuity payment are not subject to tax, which means a higher annuity payout is purchased pre-tax.
• Qualified annuity retirement plans provide an ability to fund more tax-deferred growth by avoiding taxation.
• Tax-free transfers between investments and other annuity plans.
• The requirements for RDMs may not be entirely undesirable due to the survivorship benefits of qualified accounts.

Drawbacks of Qualified Annuities

Qualified annuities do not permit cash withdrawals without levying a 10% penalty until the age of 59½, and compulsory withdrawals are not required until the age of 70½.

• Tax regulations and penalties for qualified annuities are in addition to tax penalties that concern all other annuity types, such as early withdrawal tax penalties.
• Tax rules around annuities are divorced from contractual penalties assessed by finance companies for early withdrawal or surrender of the contract.

More Resources

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• 401(k) Contribution Limits
• Brokerage
• Defined-Contribution Plan
• Income Annuity
• Net Unrealized Appreciation (NUA)
• See all wealth management resources