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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Qualified Annuity

What it is:

Qualified annuities are purchased with pretax dollars.

How it works (Example):

An annuity is a contract whereby an investor makes a lump-sum payment to an insurance company, bank or other financial institution that in return agrees to give the investor either a higher lump-sum payment in the future or a series of guaranteed payments.

Annuities are either qualified or non-qualified based on the types of funds the investor uses to purchase the contract. Thus, the same annuity can be considered qualified for one owner but non-qualified for another owner -- the difference is not the nature of the annuity itself but rather the nature of the funds with which it was purchased. Non-qualified annuities are usually purchased by an individual or entity, whereas qualified annuities are purchased with either pretax dollars or tax-deductible contributions, usually through some sort of employer retirement plan.

  Assume you'd like to buy an annuity that will provide guaranteed monthly payments of $1,000 for as long as you live after you retire. The insurance company may require you to deposit, say, $175,000 now to obtain this guaranteed future stream of income. If you purchase this annuity with after-tax dollars, then the annuity is considered non-qualified. If, on the other hand, your employer offered this annuity as part of its pension plan, you might be able to purchase the annuity with pretax dollars and thus reduce the amount of your taxable income.

The earnings on a qualified annuity are taxable at the owner's ordinary income tax rate (rather than the lower long-term capital gains rate) when they're withdrawn. This means that qualified annuities not only allow the owner to defer taxes on the original contribution, they allow the owner to defer taxes on the earnings as well.

However, owners of qualified annuities will usually pay more out in taxes when their withdrawals begin than owners of non-qualified annuities will because the owners of the non-qualified annuities have already paid taxes on the money they used to invest in the annuity. So part of the monthly annuity payments from a non-qualified annuity are considered a return of capital and is thus not taxable.

Although there is no cap on how much a person or entity can invest in a non-qualified annuity, there is a cap for qualified annuities that is dependent on the owner's income and participation in other qualified retirement plans. There are no required withdrawals with non-qualified annuities, although some states or specific insurance companies may require this. This is not the case with qualified annuities, which also require the owner to begin taking distributions from the annuity by age 70 1/2.

Upon the owner's death, if he or she has named someone other than the spouse as the beneficiary of the annuity, that person is taxed on the annuity’s gains at the ordinary tax rate instead of getting a step-up in basis as would be the case if he or she had inherited mutual fund shares.

Why it Matters:

Qualified annuities have attractive tax advantages because they help reduce taxable income and accumulate tax-deferred earnings. For these reasons, they are frequently a better choice than non-qualified annuities, and there is usually no additional benefit from holding qualified annuities in IRAs or other tax-advantaged accounts.

Fees are a major source of controversy for annuities. There are often front-end loads, state taxes, annual fees based on a percentage of the account value, early withdrawal penalties, etc., and they may offset much or all of an annuity’s tax advantages. Pressuring sales tactics and less-than-transparent disclosure have also tarnished the image of annuities, so wise investors should read these disclosure materials and ask his or her financial consultant plenty of questions.

Although annuities are controversial, they may be good bets for some income investors. Ultimately, the appropriateness of an annuity is dependent on the investor’s financial goals, tax situation and the types of annuities available. Inflation and interest rate expectations may affect the type of annuity an investor chooses, as will the investor’s wishes for his or her dependents and heirs.