You may have heard the terms “qualified” and “nonqualified” when talking about variable annuities, but what does that even mean?
As with any financial decision, be sure to consult a financial expert with your needs in mind. Independent insurance agents understand how taxes can impact your retirement — and ultimately, your peace of mind in your later years.
Whether you need help understanding the fine print or how to best address your tax liability, independent insurance agents are here to answer any questions you may have.
First, What Is a Variable Annuity?
First, an annuity is a financial contract between you, aka the “annuitant”, and an insurance company. One of the primary goals of an annuity is to provide a steady stream of income during retirement.
In exchange for a regular series of payment or a lump-sum payment paid to the insurer, the annuitant gets regular disbursements that can start either immediately or at a predetermined future date — your call.
Now, a variable annuity is a specific type of annuity where the underlying investment has various rates of return based on the type you've chosen and its performance in the stock market.
This means the annuitant may get different amounts of payout instead of fixed-rate annuities, which provide a consistent amount of cash flow regardless of the investment's performance. In essence, a variable annuity is chosen to stay ahead of inflation while also risking inconsistent rates of return that might be higher or lower than fixed annuities.
And without trying to get even more complicated, there are also qualified and nonqualified versions when it comes to variable annuities too. This all relates to how a policyholder’s income is taxed when the annuity is funded.
How the IRS Defines Qualified and Nonqualified Annuities
The Internal Revenue Service (IRS) has its own definitions of which annuities are tax-exempt until withdrawal. And it goes like this:
Basically, a “qualified” annuity is a retirement savings plan that's funded with pre-tax dollars of an individual’s gross earnings. And in this scenario, taxes are postponed until withdrawals are made after retirement where they are taxed just like ordinary income.
On the other hand, an annuity that is funded with post-tax dollars is a "Nonqualified" annuity. Taxes are paid in the same year the contributions are made.
But, distributions from a nonqualified annuity are not subject to any income tax on the contributions. Instead, taxes may be owed to the IRS on the investment gains which are typically a smaller portion of the annuity account.
How Are Variable Annuity Distributions Taxed?
If payments from the variable annuity are taken in the form of an annuity payout, like a distribution taken out over a predetermined period of time, each payment is divided into:
- A return of the original investment, which is excludable from gross income.
- Earnings from the investment, which are taxed at ordinary income tax rates.
The percentages of the return and earnings of the investment are based on the type of payout at the annuitant's current age. Age plays a big factor here, and when a policyholder takes a distribution before reaching age 59½, there's a hefty 10% early withdrawal penalty tax on earnings that is imposed by the IRS. On top of that, there will also be some fees issued by the insurance company.
Nonqualified annuities purchased after August 13th, 1982, are taxed under something called a "last-in-first-out" protocol. In short, this means the first withdrawals made by the policyholder will be taken from accrued interest and taxed as ordinary income. After the interest has been fully taxed, the remaining principal will be free of taxes.
More Rules from the IRS on Annuities
If you’re looking to learn more about the rules governing qualified annuities from the IRS, be sure to read Publication 575 Pension and Annuity Income for more information.
There are loads of important things to know about in there. But if you’re not into reading IRS-created publications, an independent insurance agent can help answer all your questions and guide you to the right investment option for you.
Which Is a Better Choice for Your Retirement?
When it comes to taxes, you’ll end up paying 'em one way or another, so choosing a qualified or nonqualified plan isn’t a straightforward decision. Variable annuities are no exception, and many folks out there who have maxed out their 401(k) and/or IRA may look to variable annuities to funnel their employment income into investments.
As with any financial decision, it ultimately comes down to your personal needs and goals. Obviously, everyone wants to avoid paying taxes against an uncertain future, which typically makes qualified annuities a clear choice.
But those who have a significant amount of savings and investments may look to nonqualified variable annuities to ride the market’s success while taking the hit in taxes in the same year.
And again, if you're still just unsure about variable annuities, your independent insurance agent can walk you through it all. They deal with this kind of thing every day and know exactly how to find the right investment for you.
What's So Great about Independent Insurance Agents?
Variable annuities are complex, and searching through options can be confusing, time-consuming, and frustrating. An independent insurance agent's role is to simplify the process.
They’ll make sure what you buy meets your unique needs. And, they’ll break down all the jargon so that you understand exactly what you're getting.
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