Qualified Annuity

Qualified Annuity

A qualified annuity is a retirement account funded with pre-tax dollars. Contributions reduce taxable income in the year they’re made, and both contributions and earnings grow tax-deferred. Taxes are owed when the owner takes distributions, which are taxed as ordinary income.

Key takeaways

• Funded with pre-tax dollars; contributions typically deductible or made within a tax-advantaged retirement plan.
• Earnings grow tax-deferred; withdrawals in retirement are taxed as ordinary income.
• Non‑qualified annuities are funded with after-tax dollars; only the earnings are taxed on withdrawal.
• “Qualified” and “non‑qualified” are IRS classifications that determine tax treatment and reporting rules.

How it works

• Contributions are made without income tax withholding, lowering taxable income for the contribution year.
• Money in the annuity grows tax-deferred while no withdrawals are taken.
• When distributions begin (annuitization or withdrawals), both contributions and earnings are taxed as ordinary income for qualified annuities.
• Non‑qualified annuities: contributions are already taxed, so withdrawals first come from earnings (which are taxable) under a last-in-first-out rule for many contracts.

Types and where qualified annuities appear

Qualified annuities are commonly part of employer-sponsored or individual tax-advantaged plans, including:
* Defined benefit (pension) plans — employer promises a specific payment stream in retirement.
* 401(k) plans — defined-contribution plans for private-sector employees; annuity options can be offered within 401(k) accounts.
* 403(b) plans — retirement plans for certain public employees and employees of tax-exempt organizations.
* Individual retirement accounts (IRAs) — can be funded pre-tax (traditional IRA) and, in some cases, invested in annuity contracts that receive qualified tax treatment.

An annuity contract itself can be designated as qualified when used within these tax-advantaged plans and when it complies with IRS rules.

Important IRS rule for non‑qualified annuities

Non‑qualified annuities purchased after Aug. 13, 1982, typically use a “last-in, first-out” (LIFO) tax treatment: withdrawals are treated as coming from earnings first (taxable), and principal (already taxed) is accessed last and is not taxed.

Fixed vs. Variable annuities (brief)

• Fixed annuities: provide predictable periodic payments or a guaranteed interest rate.
• Variable annuities: payments depend on underlying investment performance; potential for higher returns and higher risk.

Both fixed and variable annuities can be issued inside qualified plans, subject to plan rules.

Annuity vs. IRA

• An IRA is a type of tax-advantaged retirement account that accumulates savings and can hold many investments.
• An annuity converts a lump sum or series of payments into a stream of income, often for life. Annuities can be held inside IRAs or other qualified plans, or purchased outside them (non‑qualified).

Pros and cons (summary)

Pros:
* Immediate tax benefit from pre-tax contributions.
* Tax-deferred growth can accelerate long-term accumulation.
* Can provide lifetime income if annuitized.

Cons:
* Withdrawals taxed as ordinary income.
* Early withdrawals may incur penalties and required minimum distributions (RMDs) may apply.
* Investment and contract fees (especially with variable annuities) can reduce net returns.

Bottom line

A qualified annuity offers tax-deferred retirement savings because it’s funded with pre-tax dollars and governed by IRS rules for qualified plans. It can provide predictable retirement income and immediate tax relief while working, but distributions in retirement are subject to ordinary income tax. Consider plan details, fees, and whether the annuity is part of a larger qualified account when evaluating suitability.