Tax-Qualified annuities are used in connection with tax-advantaged retirement plans, such as defined benefit pension plans, Section 403(b) retirement plans (TSAs), or IRAs. Premiums for qualified annuities are generally paid with pretax dollars, as are any investments purchased for use in a qualified retirement plan.
Alternatively, any annuity not used to fund a tax-advantaged retirement plan or IRA is considered a non-qualified annuity. Contributions to nonqualified annuities are made with after-tax dollars–premiums are not deductible from gross income for income tax purposes.
Taxation of the Account When Monies are Withdrawn
You are taxed when you withdraw money from the annuity. If you buy the annuity with pretax money (qualified annuity), then the entire balance will be taxable. If you use after-tax funds (non-qualified annuity), however, then you’ll be taxed only on the earnings.
For non-qualified annuity contracts, the tax rule on withdrawals is “interest and earnings first.” Under this rule, interest and earnings are considered withdrawn first for federal income tax purposes. For example, if someone invested $25,000 in a fixed or variable annuity and the contract is now worth $45,000, the first $20,000 withdrawn is taxable. The remaining $25,000 is not taxed because it is considered a return of principal. Withdrawals are taxed until all interest and earnings are withdrawn; the principal then can be withdrawn without tax.
The “interest and earnings first” rule is intended to encourage the use of annuities for long-term savings and retirement. Congress decided that the advantage of tax deferral should not be accompanied by the ability to withdraw principal first, with no tax payable until all principal is withdrawn.
Different rules apply to tax-qualified annuities (such as IRAs), under which withdrawals are taxed on a pro rata basis to the extent there were any after-tax contributions made to the contract.
Taxation of Annuity Payouts
Non-qualified annuities require tax payments on only the earnings. The amount of taxes on non-qualified annuities is determined by something called the exclusion ratio. The exclusion ratio is used to determine what percentage of annuity income payments is taxable and how much is not. The idea is to determine the amount of a withdrawal or payment from an annuity is from the already-taxed principal and how much is considered taxable earnings.
The exclusion ratio involves the principal that was used to purchase the annuity, the amount of time the annuity has existed and the interest earnings.
In summary, when it comes to taxes, the most important piece of information about your annuity is whether it is held in a qualified or non-qualified account.
|Qualified Annuity||Non-Qualified Annuity|
|Funded||Untaxed Money||After-tax funds|
|Payments||Taxable as income||Taxation determined by exclusion ratio|