When planning for retirement, consumers often encounter various financial instruments, each with their unique characteristics and benefits. Among these, non-qualified annuities stand out as a distinct option that offers specific advantages for certain people. Unlike their qualified counterparts, these financial products operate under different rules and can serve as valuable tools under the right circumstances.

Let’s take a closer look at what these circumstances entail and if they might apply to your own financial goals…

What makes an annuity “non-qualified”?

A non-qualified annuity is fundamentally an insurance contract purchased with after-tax dollars. This means the money you use to buy the annuity has already been taxed, unlike contributions to traditional IRAs or 401(k)s. The “non-qualified” designation simply means the annuity isn’t part of an employer-sponsored retirement plan or IRA, and your contributions aren’t tax-deductible.

The freedom from retirement plan restrictions makes these annuities more flexible in many ways. There are no annual contribution limits, no income restrictions, and no rules about when you must start taking distributions. This flexibility can make them particularly attractive to investors who have already maxed out their traditional retirement accounts or are looking for additional tax-deferred growth opportunities.

The tax treatment

The taxation of non-qualified annuities follows a unique pattern that both helps and constrains investors. While you don’t get an immediate tax break on contributions, any earnings within the annuity grow tax-deferred until you withdraw them. This tax deferral can be powerful, allowing your money to compound over time without annual tax bills eating into your returns.

When you eventually take distributions, the tax treatment follows what’s known as the “last-in-first-out” (LIFO) principle for withdrawals. This means that earnings come out first and are taxed as ordinary income. Once all earnings have been withdrawn, your principal comes out tax-free since you already paid taxes on that money.

For example, if you invested $100,000 in a non-qualified annuity and it grew to $150,000, the first $50,000 you withdraw would be considered earnings and taxed as ordinary income. The remaining $100,000 would come out tax-free. This differs significantly from how qualified annuities work, where all distributions are typically fully taxable.

Investment options and growth potential

Non-qualified annuities come in several varieties, each offering different ways to grow your money. For example…

• Fixed annuities: provide a guaranteed interest rate, much like a certificate of deposit but often with higher rates. This can appeal to conservative investors who prioritize predictability over growth potential.
• Variable annuities: allow you to invest in a selection of mutual fund-like accounts called sub-accounts. Your returns depend on the performance of these investments, offering higher growth potential but also greater risk. These can be appropriate for investors with longer time horizons who can tolerate market volatility.
• Indexed annuities: represent a middle ground, linking returns to a market index like the S&P 500 while providing some downside protection. They typically offer lower returns than variable annuities in strong markets but protect against losses in down markets.

Strategic uses in retirement planning

Non-qualified annuities can serve multiple purposes in a comprehensive retirement strategy.

• Guaranteed income stream for retirement: By annuitizing the contract, you can receive regular payments for a specified period or for life, helping to ensure you won’t outlive your savings.
• Estate planning: They typically include a death benefit and allow you to name beneficiaries who can receive the assets directly, bypassing probate. This can simplify the transfer of wealth to your heirs, though it’s important to understand that beneficiaries will owe taxes on any earnings they receive.
• Tax-deferral strategy: When they’ve maxed out other retirement accounts. The unlimited contribution amount can make them particularly useful for high-income earners who want to save more for retirement in a tax-advantaged way.