What Is a Non-Qualified Annuity, and How Does It Work?

With rising inflationary pressures, it’s more important than ever to have a solid retirement corpus in place. However, for younger generations, like Millennials and Gen Z, who put experiences before money, the present has always been more important than the future.

A ‘soft savings’ trend existed among the younger folks wishing to break free from traditional financial constraints. However, the current economic turbulence is making the next-gen savers worried for their post-retirement lives.

Many have started exploring their available options for a comfortable and peaceful (preferably early) retirement. According to Investopedia, a good retirement corpus must meet all necessary expenses from the time of one’s retirement till death. One powerful product in this regard is annuities.

Though considered to be investment instruments, annuities are insurance vehicles that guarantee a steady flow of income after retirement. They offer the assurance that one will not outlive their retirement savings.

Annuities can be qualified or non-qualified – the former funded with pre-tax dollars and the latter with post-tax dollars. In this article, we will exclusively focus on non-qualified annuities, how they work, and their benefits.

Table of Contents

The Basics of a Non-Qualified Annuity

The term ‘non-qualified annuity’ has little to do with the way the income is paid out upon retirement. Rather, it has to do with where the money to purchase the product came from and how the payments are taxed.

As aforementioned, non-qualified annuities are purchased using after-tax dollars. In other words, it’s the money on which taxes have already been paid. Unlike a qualified annuity, there are no tax deductions available. This means a non-qualified annuity’s withdrawals are subject to ordinary income tax.

However, tax-free returns on the principal are received once the withdrawals are made from the original investment after earnings are exhausted.

How Does This Insurance Product Work?

Let’s learn more about a non-qualified annuity to understand how it works and when investing in this product makes sense. As the owner decides to ‘annuitize’ or convert their non-qualified annuity payments into a lifetime income stream, each payment becomes partially taxable.

This means a part of the payment is a tax-free return on the principal, whereas the remaining amount becomes taxable. Such an ‘exclusion ratio’ makes it possible to diversify the taxable earnings over several years. Once all the principal is used up, the remainder payments become fully taxable.

Besides the exclusion ratio, the Last-In-First-Out (LIFO) method is also important to remember. This is applied to non-qualified annuity withdrawals. According to it, the latest earnings will be withdrawn before the principal. Due to taxable earnings, a larger early withdrawal may lead to higher taxation.

For instance – suppose an owner decides to make an early withdrawal of $6000 from their non-qualified annuity. Out of this, $4000 was their latest earnings. The same becomes subject to taxation.

However, given that the payments are received in a tax-deferred account, non-qualified annuities help save a substantial amount. Those looking to protect their assets against annual taxation must consider buying this insurance product.

According to 1891 Financial Life, one good strategy to optimize the annuity’s potential is laddering or buying multiple products at varying interest rates. This way, it’s possible to stagger the dates of payout so that there’s more time for the annuities to gather value.

Why Purchase a Non-Qualified Annuity

The annuity market size is estimated to have a CAGR of 3.3% between 2023 and 2029, with a value of $5,328.1 billion in 2022. Let’s look at some major reasons why people are particularly interested in buying non-qualified annuities.

The most important reason to invest in these products is the guaranteed income stream that can be availed until one’s demise.
The tax-deferred growth (or absence of immediate tax implications) allows the investments to grow at a substantial gain rate.
Unlike Individual Retirements Accounts (IRAs), non-qualified annuities have no annual contribution limits, making them highly flexible products.
Likewise, there are no mandatory withdrawal age limits which offer greater control over post-retirement income.
Non-qualified annuities help in estate planning. Though its payments end upon the owner’s demise, provisions may be made for someone to receive the residual balance. As a result, the product is useful for transferring wealth to heirs.

Making an Informed Choice

For those looking for additional retirement-savings options (besides the traditional routes), non-qualified annuities are an attractive tool. They allow the owner’s money to compound over time sans the yearly tax drag.

Non-qualified annuities are usually chosen by folks who have maxed out their employer-sponsored retirement plans. But even those who are not covered by a workplace scheme can invest in these products. Unlike qualified annuities, they do not have annual contributions or withdrawal age limits.

One thing the two have in common is an early distribution penalty levied for withdrawals made before the age of 59.5 years. Though both offer steady income post-retirement, some differences must be considered for an informed choice.