Regardless of the type of annuity account you own (fixed, indexed, immediate, or variable) it will fall into one of two categories; qualified or non-qualified. This is to say that an annuity cannot be both qualified and non-qualified. It is one or the other. There are significant differences between the two and understanding the differences can help you plan for taxes, distributions, exchanges and rollovers.
A qualified annuity is simply an account where taxes have not yet been paid on the principal, any contributions or growth in the account. Common examples of a qualified account are IRA’s, 403(b)’s, 401(k) rollovers and various other retirement plans. All distributions from a qualified annuity (principal, interest, or investment gains) are subject to income taxes.
Owners of a qualified account will be required to take mandatory distributions by the IRS – usually at age 70 1/2. These distributions are based on your life expectancy and must be reported as income each year. You can begin withdrawing from your qualified account at age 59 1/2 if you wish. These withdrawals will also be taxable, but not subject to penalties mandated by the IRS.
You can rollover a qualified annuity to another qualified account without creating a taxable event. This might be done to increase the return on your policy or to change investment strategies. However, the same rules will apply when it comes to taxes. So long as you are in a taxable income bracket, income taxes will be due on any voluntary or mandatory distributions from the new account.
A non-qualified annuity is one where taxes have already been paid on the principal investment. Premium deposits could come from a mature certificate of deposit, a checking or savings account, a brokerage account, or an existing non-qualified annuity.
Only the earned interest is taxable in a non-qualified annuity – and that is only when the interest is withdrawn. If you ever decide to withdraw the principal of the account, then taxes would not be due on that amount. However, you have two options with the earned interest: You can either withdraw it as needed or reinvest it, tax deferred, for a later date.
If you choose to withdraw the interest, you must wait until age 59 1/2 even though this is not technically a retirement account. Otherwise, the IRS (not the annuity company) will penalize you for an early distribution. However, you will never be forced by the government to take your interest or principal out at any age.
You can also choose to reinvest your interest gains. This highlights one of the most significant benefits of a non-qualified annuity. If the gains are reinvested, then they grow tax deferred for as long as you wish. This way, your funds will benefit from the effects of compounding interest. The unneeded taxable income now grows tax deferred and would not be declared each year like it would with a certificate of deposit or money market account. This is a wise choice if you wish to reduce taxable interest gains in your overall investment portfolio.
This exchange is only possible from one non-qualified annuity to another. This allows you to invest in a new annuity while avoiding taxes on the deferred interest not yet withdrawn from the old annuity. You might do this to increase the returns on your annuity account and/or to lock in a higher interest rate for a set period of time. If your annuity is mature and total liquidity is not an issue, then a 1035 tax free exchange can benefit your investment returns.
In summary, annuities will always fall into one of the above two categories. How the account is taxed, distributed, rolled over, or exchanged will vary depending on your needs and IRS regulations. It is important to discuss all of your options with an experienced annuity advisor and your accountant before making any changes. If you wish to know more about these accounts or are in need of advice, please contact our annuity experts at Hyers and Associates today.