Qualified Annuity

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21 Aug, 2024

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Qualified annuities are IRS (Internal Revenue Service) approved retirement savings plans people purchase by utilizing pre-tax dollars. Such annuities can help people save for retirement and have an income stream after they stop working. Moreover, deposits into these annuities effectively lower taxpayers’ income and their tax liability.

All qualified plans must adhere to the Internal Revenue Code (IRC) in operation and form. Furthermore, all funds one deposits into such annuities should be earned income. These annuities can receive investments and grow tax-deferred. Note that the federal government does not levy taxes on the earnings generated on the investment until after one’s retirement when distributions are paid out.

What Is A Qualified Annuity?

The qualified annuity refers to a tax-advantaged insurance contract that persons can purchase using pre-tax dollars. Such an annuity can help one reduce their taxable income and build a retirement corpus that can help meet all post-retirement expenses.
Some popular types of qualified annuity plans are IRAs, defined benefit plans, and TSAs.
There are various qualified annuity benefits. For example, they provide individuals with tax-deferred growth and safeguard them from market volatility.
A noteworthy difference between a qualified annuity and a non-qualified annuity is that the former has contribution limits set by the IRS while the latter does not.

How Does A Qualified Annuity Work?

The qualified annuity refers to a savings plan purchased by one for retirement with pre-tax dollars. Individuals put their funds in such annuities with their pre-tax dollars. Contributions made to such annuities can decrease one’s taxable income. Moreover, people only owe taxes on the funds set aside in their retirement plan, including the accrued investment gains, when they receive the annuity payments. In other words, such a plan ensures no taxes are payable yearly as long as individuals do not withdraw during the year.

From the above explanation, one can find out there are a couple of phases to such annuities. They are the accumulation and distribution phases. Let us look at them in detail.

#1 - Accumulation Phase

During this phase, the contributions could get credited or invested at a specific rate of interest. This interest rate depends on the annuity type one has.

#2 - Distribution Phase

In this phase, one starts making withdrawals or receiving payments. Individuals can decide to annuitize their contract and get the payments for the remaining part of their life or a specific number of years. Having said that, if people decide to annuitize, they cannot access the contract value. This is why many individuals opt for withdrawals instead.

Note that if one withdraws funds from their annuity before turning 59 ½, the person may have to pay a 10% penalty for early withdrawal in addition to income tax on the withdrawn amount. Individuals must remember that this is applicable in the case of both qualified annuities and non-qualified annuities.

Types

Let us look at some types of qualified annuity plans.

401(k): This is a plan a company sets up to reward employees. This plan is facilitated via the SECURE Act (Setting Every Community Up for Retirement Enhancement), which makes it easier to include annuities in 401(k) plans.
Defined Benefit Plans: These savings plans require companies to commit to a certain payment schedule. It involves paying regular installments or paying a lump sum on the basis of an employee’s earnings history.
403(b): This plan is available to tax-exempt organizations only. It principally includes public service employees and teachers.
Tax Sheltered Annuity or TSA: It allows for more flexibility on the contribution amount. This is impossible with the majority of the plans. It is popular among healthcare workers and teachers.
SARSEP Plan: It is a salary deduction arrangement that involves employees allowing their employer to contribute a part of their income or salary to their IRA (Individual Retirement Account).
Individual Retirement Account: It refers to a savings plan that allows one to make pre-tax contributions up to a specific yearly limit.

Examples

Let us look at a few qualified annuity examples to understand the concept better.

Example #1

Suppose David, a 25-year-old individual, purchased a qualified annuity to ensure he can easily meet all his post-retirement expenses. He contributed a certain portion of his salary every year toward the annuity. Against the contributions made each year, David claimed an income tax deduction while filing his taxes. As a result, his tax liability decreased every year he made the contributions.

After turning 60, he retired and received the total contributions in addition to the interest earned on the annuity investments. Note that he had to pay taxes on the distribution paid out after his retirement.

Example #2

Suppose Company ABC provides a qualified annuity known as ABC Personal Retirement Annuity. The minimum investment amount is $10,000; one can select from 50 funds. One can self-manage this annuity, depend on automated management, or invest in funds focusing on a specific sector. The annual fee payable is 0.20% for contracts bought less than $900,000. For contracts purchased for over $900,000, the annual fee payable is 0.1%.

Contribution Limits

The IRS sets certain contribution limits for such annuities. Such limits aim to prevent taxpayers from shielding excessive earnings from taxation. One must note that these limits can vary depending on what plan retirement account an individual utilizes to fund an annuity. Examples of retirement accounts or plans are 401(k)s, employer-sponsored plans, or IRAs (Individual Retirement Annuities).

One must know the caps set by the IRS to adhere to the regulations of the federal government’s revenue service.

Taxation

A key feature of such annuities is their tax-advantaged status. As noted above, individuals contribute to the retirement account using pre-tax dollars. Hence, they do not have to make tax payments in the year in which they make the contributions. Moreover, the income individuals earn on their annuity investment increases in value on a tax-deferred basis. As a result, individuals can enjoy the benefits of compounded investment returns with time.

As mentioned earlier, one typically needs to pay taxes upon making withdrawals from their annuity or when they receive payouts. Note that ordinary tax rates apply to the income generated via the annuity investment.

The tax deferral feature of these annuities can offer potential tax savings besides the opportunity to benefit from long-term growth.

Advantages And Disadvantages

Let us look at the benefits and limitations of such annuities.

Advantages

A major qualified annuity benefit is that it offers tax-deferred growth.
Such annuities provide individuals with a reliable income stream after retirement.
These annuities offer various investment options for varying individual preferences and risk profiles.
They can offer protection from volatility in the market.
Multiple features of such annuities are customizable.
It aids in efficient estate planning as it enables people to designate beneficiaries.
The premiums are tax-deductible.

Disadvantages

Typically, such annuities have withdrawal restrictions. Moreover, individuals may have to pay surrender charges to access funds early.
These annuities may not offer flexibility. This is because the alterations to the annuity contract or adjustments to the investment strategy could be limited, or they might attract penalties or additional costs.
These are complex products with multiple riders, contract terms, and features. One must understand all the details associated with such products before purchasing them.

Qualified vs Non-Qualified Annuity

Understanding the concepts of qualified annuity and non-qualified annuity can be challenging for individuals who do not know how annuity investments work in general. To comprehend their meaning and purpose while avoiding confusion, let us look at their key differences:

Qualified Annuity	Non-Qualified Annuity
Individuals utilize pre-tax funds to buy such an annuity.	Persons use after-tax funds to purchase non-qualified annuities.
The IRS limits the total amount of contributions one can make during a year.	There is no contribution limit.
Distributions of both earnings and principal are subject to taxation as the taxpayer’s income.	Tax is imposed on only the distributions of the earnings generated from the investment. The contributions are not subject to taxation upon receiving the payouts.
The distribution of funds must begin by the age of 70 ½, per IRS requirement.	There is no such IRS requirement. That said, the state laws may vary.

Frequently Asked Questions (FAQs)

1. Can you roll over a non-qualified annuity?

Yes, it is possible. This is because such annuities are financial products that one sets up utilizing pre-tax dollars.

2. Can a qualified annuity be jointly owned?

Yes, two persons can jointly own an annuity. However, owing to tax code alterations that took place in 1986, joint ownerships do not have tax advantages. Also, one must note that joint ownership can lead to complications concerning the contract’s administration, especially if one of the owners dies.

3. Can you 1035 a qualified annuity?

No, the IRS only allows 1035 exchanges of non-qualified annuities between insurance companies. Such an exchange allows one to switch companies while deferring taxes. This ensures the annuity remains updated with the latest benefits available.

4. What happens when you inherit a qualified annuity?

One can do any of the following things after inheriting such an annuity:
- Choose a one-time payment
- Keep it as an owner
- Roll the amount into an inherited IRA
- Choose a multiyear payout