Can Nonqualified Annuity Be Rolled Into a Roth Account?

A traditional qualified annuity, such as an employer 403(b) plan or individual retirement annuity, must meet Internal Revenue Service requirements. You can't transfer or forfeit a qualified annuity, and the IRS limits the amount of money you can kick in each year. Your contributions are tax-deductible or are pre-tax-deferred salary, but distributions are taxed as normal income. You have to fork over a 10 percent penalty on withdrawals before age 59 1/2, and you must begin taking required minimum distributions after age 70 1/2. However, you can take penalty-free distributions from a 403(b) if you leave your job.

A qualified annuity can be a Roth account that accepts after-tax contributions and provides tax-free distributions. Your employer may allow you to divide your 403(b) into separate Roth and traditional accounts. Roth accounts will tax and penalize earnings withdrawn before the fifth anniversary of the original contribution. You’ll also pay taxes and penalties on earnings withdrawn before age 59 1/2, unless it’s an employer plan and you leave the job. You can roll a 403(b) into a Roth IRA, but you can’t perform a transfer in the other direction.

At first glance, you might mistake a nonqualified annuity for a Roth one. Both accept after-tax contributions, and both shield earnings from taxation. However, you can contribute any amount to a nonqualified annuity, and part of the annuity payments are taxable income. The “exclusion ratio” defines the tax-free portion of annuity payments and is set when the payments begin. Earnings withdrawn before age 59 1/2 are slapped with a 10 percent penalty. The IRS considers all withdrawals to be earnings until the account value falls below the amount you put in.

No nonqualified account can be rolled into a qualified account, traditional or Roth. However, you can contribute money from a nonqualified account to a qualified one as long as you observe IRS limits. Insurance companies issue annuity contracts, and these normally include a death benefit. Some nonqualified policies continue to pay the annuity to a surviving spouse, while others ask the spouse to choose between the continuing annuity payments or the death benefit. A beneficiary of an individual retirement annuity can ask the custodian to issue a new annuity using the balance remaining in the account. Annuity payments avoid the 10 percent penalty on early withdrawals, even if you start them before age 59 1/2.