Annuities are tax-deferred, meaning the money invested in the annuity grows without being taxed until the payout occurs. The annuitant does not pay taxes on the earnings while they remain in the annuity, but taxes must be paid when the money is withdrawn. The rate at which payouts are taxed depends on how an annuity is funded.
The way an annuity is funded determines how it will be classified: as qualified or non-qualified. Qualified annuities are paid for with pre-tax dollars, while non-qualified annuities are funded with post-tax dollars. This article is going to focus on non-qualified annuities and the specific way such an annuity is taxed.
What is a Non-Qualified Annuity?
An annuity is considered non-qualified if the annuitant purchases the account with money that he or she has already paid taxes on. Non-qualified annuities can have either immediate or deferred payouts.
When the annuitization period begins for a non-qualified annuity, a portion of the annuitant’s payouts will be considered a return of premium and will not be subject to tax. The annuitant does not pay taxes on the principal amount he or she used to purchase the annuity since that was after-tax money. Instead, only the earnings on the annuitant’s initial investment are taxable. The portion of the withdrawal that is subject to tax is taxed as ordinary income.
Non-qualified annuities use a method called the Exclusion Ratio to determine how much of the withdrawal correlates to the principal investment and how much comes from earnings. The exclusion ratio is described in greater detail below.
Since income taxes are only levied on the earnings and interest of a non-qualified annuity, it must be determined which portion of a withdrawal from a non-qualified annuity is subject to tax. The IRS discerns how much of the withdrawal is taxable by using a calculation known as the exclusion ratio. This ratio is based on the length of the annuity, the principal and the earnings.
If a non-qualified annuity contract specifies that the account will pay the owner for the rest of their life, the exclusion ratio will take their life expectancy into consideration. It is important for the exclusion ratio to take life expectancy into account because the aim is to spread the principal and earnings over the owner’s lifetime. If the annuitant lives longer than his or her calculated life expectancy, all payouts received by the annuitant beyond that time are taxed as income.
Example of a Non-Qualified Annuity
Jerry, a 62-year-old man, opens an immediate annuity account with a lump-sum premium payment of $100,000. The insurance company determines that Jerry has a 25-year life expectancy, and promises to pay Jerry a monthly payout of $425 for the rest of his life.
The insurance company must spread Jerry’s initial $100,000 investment over 25 years, which would equal roughly $333 per month. However, Jerry’s contract entitles him to $425 per month, so that is the payout he will receive each month.
The IRS will not tax $333 out of his $425 payout each month because it considers $333 a tax-free return of Jerry’s original principal. The remaining $92 per month is taxable and will be taxed according to Jerry’s ordinary income tax.
Exclusion rate calculation:
$100,000/($425 per month x 300 months) = 78.4%
In Jerry’s case, the exclusion ratio is 78.4%, because this is the amount of each monthly payout that is excluded from taxes ($333). The remaining 21.6% of each payout is subject to tax ($92).
Advantages of a Non-Qualified Annuity:
Disadvantages of a Non-Qualified Annuity:
The Bottom Line
Like other decisions that need to be made when purchasing an annuity, there are both pros and cons to funding the account with non-qualified money. There is no one-size-fits-all approach, and each investor should consider their own situation when deciding how to fund his or her annuity. Since annuity products can be complicated and expensive to set up, talk to a tax adviser about the tax implications before buying one.
Special thanks in preparing this summary of “What is a Non-Qualified Annuity?” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.