Qualified vs. nonqualified
- You fund a qualified annuity with pretax dollars. For example, if you use money from a traditional 401(k) or IRA to buy or add to the annuity, it’s considered qualified. The earnings and interest from the annuity are tax deferred, but withdrawals are taxable.
- A nonqualified annuity is funded with after-tax dollars. It’s money you’ve already paid taxes on and that isn’t in a tax-deferred retirement account.
- An annuity funded with after-tax Roth dollars—whether from an IRA or workplace retirement plan—also can grow tax deferred, but withdrawals are tax free if you meet certain criteria. This type of annuity is neither qualified nor nonqualified.
Payments from a qualified annuity are taxable at your regular income rate when you receive them. But payments from a nonqualified annuity are treated differently: You generally owe taxes only on the earnings portion of your payments. (The amount is determined using a formula called an “exclusion ratio.” It compares the percentage of payments that came from the pretax amount used to buy the annuity with any earnings, along with your life expectancy. If you live beyond your expectancy, your remaining payments become fully taxable.)
Note that if you fund an annuity with money from a Roth account (pretax investments with potentially tax-free withdrawals), your annuity payments could also be tax free. Check with a knowledgeable tax professional to review your situation.
Are annuities a good investment?
Whether an annuity is right for you depends on your needs and retirement goals.
In some cases, an annuity can make sense if you want regular, predictable payments to help cover expenses during retirement. (Keep in mind that you don’t have to use your entire retirement account to purchase an annuity. Instead, you can use some of it to buy an annuity that can meet your basic needs, and keep the rest in the account for future growth and to cover extras.)
Also, because some annuity contracts are complicated and come with exclusions, limitations, benefit reductions and fees, it’s important to run the numbers carefully. A trusted financial professional can help you learn the details and determine whether an annuity is a good choice for you.