A non-qualified annuity is an annuity funded with after-tax dollars. That's in contrast to the "qualified" status of pre-tax retirement plans such as 401(k) plans and traditional individual retirement accounts. Most commercial annuities available from banks or brokerage firms are non-qualified annuities. You can always get money out of a non-qualified annuity, but it might cost you in taxes and penalties.
The Internal Revenue Service considers distributions from non-qualified annuities the same as regular earnings. If the value has gone up since you purchased it, you will owe tax on at least part of your distribution. For example, if you bought the annuity at $20,000 and the value is now $25,000, the first $5,000 you withdraw is taxable income. Annuities are taxed at ordinary income tax rates, even if the profits are from capital gains. However, if the value is still $20,000, you can take a tax-free distribution of your contributed principal.
Non-qualified annuities fall under the same IRS rules governing traditional IRAs and other types of retirement plans when it comes to premature distributions. The penalty is 10 percent on the earnings portion plus regular income tax if you withdraw before you're 59 1/2. If the value is equal to or below its original cost, you are withdrawing principal, not earnings, and therefore you are not subject to any additional tax or the 10 percent penalty.
You can avoid taxes or penalties entirely if you roll the annuity over to another type of retirement plan. The trick is to get a plan that keeps your taxable earnings and non-taxable contributions separate. Plans eligible to receive non-qualified annuity rollovers include 403(b) plans, traditional IRAs, Roth IRAs and qualified employee plans, such as 401(k)s.
After age 59 1/2, you could annuitize your contract and begin receiving regular payments. Part of these payments are taxable earnings, and another part is made up of the non-taxable return of invested capital. Of course, you could ask for that money before you hit that age, but you will be hit with an early distribution penalty.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.