Qualified vs. nonqualified annuities explained

As you save for a secure and fulfilling retirement, you may use several accounts and financial products to achieve a mix of income sources in your later years.

Annuities can be an integral part of your retirement strategy, giving you a reliable income stream later in life. When you buy a deferred annuity, you set up a contract with an insurance company where you pay either a lump sum or premiums over time. When you decide to annuitize, the company gives you regular payments that can last throughout your retirement depending on the type of payments you elect.

One factor to consider is investing in a qualified vs. nonqualified annuity. They differ in how you fund them and when you pay taxes, both of which play a role in the overall tax-efficiency of your retirement strategy.

Read on to learn how qualified and nonqualified annuity features compare as to tax treatments, contribution limits, distribution rules and more.

Qualified annuities are designed to be used with specific tax-deferred plans, such as traditional IRAs, Roth IRAs and 403(b) employer-sponsored retirement plans. While less common, some 401(k) and Profit Sharing plans also offer annuities as an investment option.

Nonqualified annuities, in contrast, are funded entirely with money you've already paid income taxes on. The tax aspect of your funding dollars makes a difference when you make withdrawals or take distributions. Unlike qualified annuities, you can withdraw your nonqualified annuity principal—also known as your cost basis—tax-free as you've already paid taxes on it. You'll still pay taxes on the earnings. Any withdrawals are treated as earnings out first.

After you annuitize your contract, federal tax law determines how much of your annuity payments are taxable and how much is tax-free based on a calculation called the exclusion ratio. This ratio is your cost basis divided by your total expected payments. Then the annuity provider multiplies the exclusion ratio by the annual payment you receive and notifies you of the tax-free portion of your payment.

Consider the differences between qualified and nonqualified annuities to help you decide which option might suit your retirement needs. Many clients have money in a mix of qualified and nonqualified annuities.

In general, you contribute to qualified annuities with pretax dollars. This can reduce your taxable income in the year designated by you as the contribution year. (Note: Roth IRAs have different requirements). Taxes are then deferred until you make withdrawals from your contract. You might consider this route if you expect to be in a lower tax bracket in retirement when you receive your payouts than you were when you put money in.

Since nonqualified annuities are funded with after-tax dollars, they don't provide an immediate tax benefit. But you only pay taxes on the earnings at withdrawal, not the principal. The potential tax advantage of this route is if you end up being in a higher tax bracket when you take the payout. When you paid taxes on the principal, you would have been taxed at a lower rate.

Because the money used to purchase qualified annuities is tax-deferred, they're subject to annual contribution limits set by the IRS. In 2024, those limits are:

• For IRAs: the lesser of $7,000 (or $8,000 if you're 50 or older) or your taxable compensation for the year
• For 401(k) and 403(b) plans: $23,000 (or $30,500 if you're 50 or older)

Nonqualified annuities have no IRS-imposed contribution limits since they don't involve any immediate tax advantages. The insurance company offering the annuity may limit your annual or total deposit amounts, but these tend to be higher than the IRS caps on qualified annuities.

Since qualified annuities are tax-deferred, they follow the same rules for required minimum distributions (RMDs) as traditional IRAs, Roth IRAs and 403(b)s. You have to take out a certain amount of money each year starting at age 73 (or 70½ for those born before July 1, 1949). For Roth IRAs, RMDs do not start until after death (for the beneficiary).

Nonqualified annuities don't have RMDs. This may be an advantage for you to consider as it allows you to control when you access your funds. If you have enough other retirement income resources and want to arrange your nonqualified annuity payments to start when you turn 75, 80 or whenever, you can.

One more tax consideration with qualified vs. nonqualified annuities is how penalties are calculated if you take an early withdrawal.

Any money you take out from a qualified annuity before age 59½ can be subject to a 10% federal tax penalty in addition to regular income taxes. Some exceptions allow you to avoid early withdrawal penalties, including withdrawals to pay for medical expenses exceeding 7.5% of your adjusted gross income and total and permanent disability.

However, if you take out money from a nonqualified annuity before age 59½, you could face a 10% early withdrawal penalty on the earnings but not the principal (since you already paid taxes on that portion).

Choosing between a qualified vs. nonqualified annuity impacts your tax situation, flexibility and financial goals. Qualified annuities offer tax advantages upfront but come with more restrictions. Nonqualified annuities provide more flexibility and a lower tax burden in retirement but without immediate tax benefits.

Consider your financial circumstances and goals when choosing between these two annuity options. However, if you've already maxed out your IRA and 401(k) or 403(b) contributions, a nonqualified annuity can provide another way to save more for retirement.

If you're interested in exploring your annuity options further and seeking expert advice, contact a local Thrivent financial advisor. They can offer personalized solutions to help you make the right choice for your retirement journey.