If you're like many young adults, you began saving for your retirement years in your 20s or 30s. You know by now federal tax laws limit the amount of money you can contribute to these accounts. No such limits apply to similarly tax efficient insurance products known as non-qualified annuities. However, do not buy one of these contracts with money you may need for an emergency. Technically, you can liquidate a non-qualified annuity, but it will cost you.
The Internal Revenue Service describes earnings that have never been taxed as qualified money. In contrast, earnings that have been taxed, such as the money you have in your checking or savings accounts, is regarded as non-qualified. You can move as much of your non-qualified money into tax deferred annuities as you like. Once your cash is inside the contract, the money grows on a tax deferred basis. When you eventually withdraw money from the account, you only pay taxes on the withdrawals that exceed your original investment. Sounds good so far, right? That's nice, but don't put your money away just yet -- there is more to the story.
While annuities are not officially classified as retirement vessels, these accounts are subject to the same withdrawal restrictions as 401(k)s and Individual Retirement Arrangements, or IRAs. In short, you have to pay ordinary state and federal income tax on your earnings when you cash in the account. And if you access the money before you reach the age of 59 1/2, you also pay a 10 percent tax penalty on your earnings. You can avoid the penalty in some circumstances, such as if you become disabled. Still, though, in most cases, taxes could erase a huge chunk of your earnings if you liquidate the account.
Annuities are essentially income insurance -- you'll want to have them for an income stream when little or nothing else is available. If you die before you withdraw all of your money, the insurance company makes money because it gets to keep the remainder of your investment, unless you choose a more expensive type of annuity that will pay the balance to your heirs or continue the annuity payments for someone else. With that in mind, insurance companies put safeguards in place to prevent people from cashing in their annuities whenever they feel like it. Deferred annuities typically begin with a "surrender" term that can last for a decade or more. And yes, you guessed it -- this will hit you in the wallet because if you liquidate your account during the surrender period, you will have to pay surrender fees that may amount to 6 or 7 percent of the contract's cash value. Add that to the taxes on your earnings and you may have very little left.
If you want to avoid surrender fees, you can access your money by making a series of periodic withdrawals based on your expected lifetime. Some annuity companies even allow you to make small penalty free withdrawals on an annual basis. The amount you can take out in this way, if any, will be spelled out in your contract. And buying an annuity that gives you the right to do that will -- you guessed right again -- probably cost you more. However, the IRS uses the last-in-first-out taxation method for withdrawals from annuities. This means you get your taxable earnings out first before you have access to your already taxed principal. You can only avoid the tax penalty if you convert the annuity to a lifetime income stream based on your life expectancy. Simply put, unless you become disabled or suffer another type of qualifying event you cannot liquidate your non-qualified annuity without paying a hefty price.