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What Is a Nonqualified Variable Annuity?
Nonqualified variable annuities are tax-deferred investment vehicles with a unique tax structure. While you won’t receive a tax deduction for the money you contribute, your account grows without incurring taxes until you take money out, either through an early withdrawal or as retirement income.
A nonqualified variable annuity is a retirement pension plan that is purchased with post-tax dollars. That is, you don’t get a tax break up front, as with an individual retirement account (IRA). Your money will grow untaxed until you start taking the money out, usually as retirement income. At that point, you’ll owe income taxes on the amount withdrawn.
Key Takeaways
- A nonqualified variable annuity doesn’t entitle you to a tax deduction in the years you contribute money, as is the case with a traditional IRA or 401(k) plan.
- You won’t be taxed on the gains in your account until you withdraw money.
- At that time, the gains will be taxed as ordinary income, not capital gains.
- Any money you take out before age 59½ will be subject to a 10% early withdrawal penalty in most cases.
How a Nonqualified Variable Annuity Works
Variable annuities are sold by insurance companies. In return for the money you invest, the insurer promises to pay you a regular stream of income. Normally, the payments begin at retirement age and continue for the rest of your life.
A qualified annuity is a type of retirement account, much like a traditional individual retirement account (IRA), that typically entitles you to a tax deduction for the amount you contribute, up to Internal Revenue Service (IRS) limits.
A non-qualified annuity is not considered a retirement account for tax purposes and doesn’t earn you a deduction—even if you are using it to save for retirement.
You make contributions to a nonqualified variable annuity with after-tax dollars, like adding money to a bank account or any other investment. The insurer invests your contributions in subaccounts, which are similar to mutual funds, of your choosing.
The value of the annuity will vary according to the performance of the investments you selected. With a fixed annuity, the insurer picks the investments and promises you a predetermined return.
The Tax Benefit
Although you don’t receive any upfront tax break with a nonqualified annuity, the earnings on your subaccounts grow tax-deferred. That is the unique tax advantage of these annuities.
With other nonqualified accounts—such as a brokerage account or mutual fund—the interest, dividends, and capital gains distributions your investments generate are taxed for the year in which you receive them. That’s true whether you take the money in cash or simply reinvest it.
The earnings in your variable annuity account become taxable only when you withdraw money or receive income from the insurer in the payout phase of the annuity.
At that point, the money you receive is taxed at the same rate as your ordinary income.
Tax on Withdrawals and Income
When you receive money from a nonqualified variable annuity, only your net gain—the earnings on your investment—is taxable. The money you contributed to the annuity isn’t taxed because you made it with after-tax dollars.
As a result, a portion of each payment you receive is treated as principal (that is, a return of your investment in the contract) for tax purposes.
How is this calculated? Essentially, the nontaxable portion of each payment is determined by the ratio of your investment in the contract to the account balance. More precisely, the tax-free and taxable portions of annuity payments are figured using a special computation explained in IRS Publication 575.
The insurance company will report the total annual payouts to you and to the IRS on Form 1099-R. The form will also show your taxable amount so that you won’t have to figure it out yourself.
Taxes at Death
The variable annuity contract may provide that at your death, a person you name as a beneficiary will receive a lump-sum death benefit. Depending on the terms of the contract, when a death benefit becomes payable to a beneficiary, some taxes may be due.
Even though this is an inheritance, the beneficiary must pay income tax on the portion of the payment in excess of your remaining investment in the contract. This is the unrecovered part of your cost for the contract that remained after the payments and withdrawals you received during your lifetime.
Whether the beneficiary is your spouse or someone else also makes a difference.
Spouse Beneficiaries
A spouse inheriting a nonqualified variable annuity usually has the option to continue the contract in his or her name. This is an option, selected up front, that sves the spouse from incurring any taxes until they start making withdrawals.
However, if the spouse chooses to take a lump-sum death benefit, the earnings become immediately taxable as ordinary income.
Other Beneficiaries
For beneficiaries who are not spouses, there are usually three options, depending on the terms of the contract: take a taxable lump-sum distribution (as mentioned above), withdraw the money over a 10-year period, or take distributions based on the beneficiary’s life expectancy.
The distributions must begin within one year after the original account owner’s date of death.
Important
Variable annuities often have high fees, including surrender charges if you need to terminate the contract early. Read the contract carefully to understand the fees you may encounter.
Other Considerations
There are other issues to consider with variable annuities, whether qualified or nonqualified.
Fees
Variable annuities entail considerable costs in the form of an insurance fee, which covers any guaranteed death benefit, as well as an administrative fee.
These fees are based on a percentage of the value of the contract and apply every year. They can average about 1.25% or more annually, depending on the insurance company and other factors.
You cannot deduct these amounts as investment expenses. They become part of your cost (investment) in the contract.
Additional Taxes
High-income taxpayers must include the taxable portion of their variable annuity income in calculating their 3.8% additional net investment income tax.
Early Distributions
As with other tax-deferred accounts intended for retirement, variable annuity withdrawals of any kind—whether a single withdrawal or a stream of monthly payments—taken before age 59½ are subject to a 10% early withdrawal penalty on the taxable portion of the payment.
The penalty does not apply if you are totally and permanently disabled. It also does not apply to a beneficiary who receives payments after your death, regardless of whether you or the beneficiary are under 59½.
Surrender Charges
If you surrender the contract, which means cashing it in before you start to receive annuity payments, you may face a significant surrender charge imposed by the insurer.
The portion of the money that represents your investment in the contract is tax-free, but any additional amount is taxable as ordinary income. If you receive less money than you paid into the contract after deducting the surrender fee, you can take a loss on your taxes.
Exchanges for Other Annuity Contracts
If you have an annuity and want to replace it, there is a way to do it that saves taxes.
Instead of cashing in a variable annuity to buy one with better terms (such as lower annual fees) and paying tax at that time on any increase over your investment, you can transfer to another contract in what is called a 1035 exchange.
The exchange is tax-free as long as the annuitants are the same in both contracts.
Withholding
The insurance company will automatically withhold taxes on the taxable portion of your annuity payments based on the rate that applies to ordinary income as if you are married with three withholding allowances (even if you are single).
You can opt out of withholding by filing IRS Form W-4P.
Why Would I Invest in an Annuity?
An annuity, qualified or nonqualified, is one way you can obtain a regular stream of income when you retire. As with any investment, you put money in over a long term, or pay it in a lump sum, and let the money grow until you are ready to retire.
There are pros and cons to annuities. They are, indeed, a guaranteed stream of money, based on the amount you pay into it during your working years. They are known for their high fees, so care before signing the contract is needed.
There’s a grim reality to annuities, too. They are sold by insurance companies. You’re betting that you’ll live long enough to get full value for your investment. The company is betting you won’t.
How Do I Choose Between a Qualified and a Non-Qualified Annuity?
Qualified annuities are most often offered by employers as a company benefit. If you don’t have access to one through an employer, you can buy an annuity directly from an insurance company and fund it with money in an IRA or other qualified retirement account.
Some qualified annuities allow pre-tax income to grow over time, with no taxes due until the money is withdrawn, usually after the person retires. Because of this tax benefit, they also are subject to IRS restrictions, including limits on the amount that can be deposited each year.
What Is a Fixed Annuity vs. a Variable Annuity?
This is one of the choices you make when you sign a contract for an annuity. A fixed annuity guarantees you a specific rate of return. This is based mostly on the amount of money you have in the account and your life expectancy. With a variable annuity, the amount of your payment is determined by the performance of the investments you choose to put your money into. Your payment will vary from month to month.
The Bottom Line
Variable annuities can be attractive from a tax perspective because you can postpone paying taxes on your investment gains until you’re ready to retire.
However, at some point, you or your beneficiaries will have to pay tax on the income earned in the contract. What’s more, the tax will be at your rate for ordinary income rather than the more favorable capital gains rate you’d pay if you made the same investments in a regular taxable account.
Before taking withdrawals from a nonqualified variable annuity—or if you inherit money from one—it is important to seek professional tax advice. A wrong move could mean a hefty tax bill.
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