An annuity is an investment product offered by an insurance company. Annuities convert your principal and interest into a steady stream of income. With a deferred annuity, you fund the annuity by making contributions for a desired amount of time. You can also use a lump sum to purchase the product and begin receiving payments right away through an immediate annuity. The interest you earn is either variable or fixed. For tax purposes, annuities are either classified as qualified or non-qualified. Although the products are similar, they have some key differences.
A qualified annuity is an annuity funded with pre-tax earnings. Qualified annuities are generally set up through an employer to provide retirement income for employees. Examples of a qualified account are IRAs, 403(b)s and 401(k) rollovers. With a qualified annuity, the employers set up a salary reduction plan, that allows workers to contribute a portion of their salary to fund the annuity. When you begin taking distributions, all of the money is taxable, including the principal.
An annuity that is not used to fund a tax-advantaged retirement plan or IRA is known as a non-qualified annuity. Annuities that are privately obtained cannot be funded with pre-tax dollars. Since the money used to fund the annuity has already been taxed, the initial investment is not subject to tax on disbursement when you retire. Non-qualified annuities allow for a 1035 Exchange between annuities. You can transfer from fixed to variable, variable to fixed, and fixed to fixed without facing the early withdrawal penalty.
Both qualified and non-qualified annuities do not allow you to take distributions until you reach age 59 1/2. If you do withdraw the funds early, you face the IRS 10 percent tax penalty on earnings. You do not pay taxes on either account until the time of withdrawal. You can also roll over qualified and non-qualified annuities into another account with the same tax status.
Unlike a qualified annuity, non-qualified annuities are not subject to federal laws governing annual contribution caps and mandatory withdrawal requirements. You can invest as much as you desire in a non-qualified annuity. You are not forced to take out the principal or interest at a certain age. With interest earnings from a non-qualified annuity, you can either withdraw as needed or reinvest it, tax deferred, until you need it at a later date. The IRS requires owners of a qualified annuity to take mandatory distributions at age 70 1/2. Distributions are based on your life expectancy and reported as income each year. Contributions made to a qualified annuity can also be reported as a deduction to reduce your taxable income.