Personal Finance

Qualified vs Non-Qualified Annuities: The Key Differences to Know

John Seetoo

Published: December 31, 2024 10:12 am

24/7 Wall Street Key Points

• The differences between qualified and non-qualified annuities can be likened to the differences between IRAs and Regular Post-Tax investments
• Annuities can be a useful tool for arranging regular retirement payments, but they may not be for everybody, and how an annuity is designed can vary widely, so matching one’s needs to the structure is crucial.
• Take this quiz to see if you’re on track to retire (Sponsored) 

Annuities are a popular vehicle for retirees to structure their post-retirement income payments. Primarily organized by insurance companies, annuities are contracts with insurance companies to invest funds for the purpose of stretching out regular payments over a prescribed time period. Annuity sales rose 23% to $385 billion in 2023, so retirees are certainly interested in them, especially with Annuities can vary in a number of ways, and the differences should be acknowledged and assessed for suitability before selecting one.

Qualified vs. Non-Qualified: Before or After Taxes

The primary two categories of annuities are Qualified, which are invested with pre-tax funds, and Non-Qualified, which are invested with after tax funds.  For an overview comparison:

Additional Annuity Categories

Annuity principal amounts are locked up into pooled investments with fixed schedule distributions. Since annuity payouts are contract based, it is important to structure them according to one’s needs, since access to principal is unavailable. 

• Immediate Annuities – This is the most common type of annuity. There is a single premium, and payouts start immediately. These can be especially helpful for those who have low retirement savings and minimal social security income. 
• Life Only – A Life Only contract guarantees the largest payout amounts but only pays to the beneficiary as long as they are alive, whether one lives for 2 years or 30 years. All payments stop upon the beneficiary’s demise. No funds for any surviving spouses.
• Extended Pay – Another version can continue making payments to one’s estate after his or her demise for up to a fixed term, such as 10 years.
• Joint-Life Immediate – This can be a joint-annuity for a couple so that payments can continue to a surviving spouse. 
• Deferred Income – If immediate income is not a requirement, one can start distributions at a contracted future date for a larger payout. This can be structured as a type of longevity insurance, in case one outlives their life expectancy projection. Similar to immediate annuities, no payments would be obligated if the beneficiary were to die before the contracted start date. 
• Fixed Rate vs.Variable Rate – The underlying investments that generate capital growth can be structured for specific amounts (which some use to pay for insurance premiums or other recurring expenses), or variable amounts, which will fluctuate with the overall market. Trade offs of guaranteed amounts usually involve smaller distributions. Both types can incur surrender charges if the annuities cash out early. The surrender charges reduce the longer the annuity remains in effect.

Tax Strategies

Scheduling distributions and structuring annuities are often in conjunction with tax-saving strategies. For example:

• Non-qualified distributions can be declared to include a non-taxable portion of invested principal. Citing an exclusion ratio calculated to reduce taxes while one is in a high bracket can save on taxes until the initial principal investment amount is mathematically exhausted.
• If one anticipates being in a higher tax bracket in the future (perhaps due to the sale of a business or property) during their retirement age, paying taxes only on interest and not the principal of non-qualified annuities can help to save on taxes. 
• According to Turbo Tax commission fees on annuities are tax deductible, so taking note to include them when filing taxes is advisable. 

This article is intended for informational purposes only. More comprehensive information inquiries should be directed towards retirement financial professionals.