Variable Annuities: Qualified or Non-qualified
(The difference is in the plan)
Running out of money is a top concern for many when it comes to retirement according to the American Institute of CPAs' Personal Financial Planning Trends Survey. Variable annuities are a tax-advantaged way to save for and create a guaranteed lifetime income.
Variable annuities can be qualified as part of a retirement plan or IRA. They can also be non-qualified and personally owned. Of course, tax benefits come with strings attached, and variable annuities are no exception.
Independent insurance agents are annuity professionals, they can help you make a smart decision.
First Things First ... What Is a Variable Annuity?
Variable annuities are issued by life insurance companies. An annuity pays the policyholder (or annuitant) a regular guaranteed income for life, or an agreed-upon number of years. Your annuity contract begins by making either a single payment or a series of payments.
There are different types of variable annuities that can be qualified or non-qualified:
- Immediate variable annuities pay income right away.
- Deferred variable annuities accumulate money in investments selected by the owner called subaccounts. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They’re not guaranteed.
- Indexed variable annuities offer partial protection from market losses and accumulate money by tracking a market index, like the S&P 500.
Who Are the Owners, Annuitants, and Beneficiaries?
An annuity policy is a contract between the insurance company, the owner, the annuitant, and the beneficiaries. It all works like this:
The owner of the policy has the sole right to the values and payments in the contract, and the owner decides who both the annuitant and the beneficiaries are. The age and sex of the annuitant is how the insurance company determines how much and when income is paid.
The annuitant and owner don't have to be the same person. If the owner passes away, the beneficiary receives the proceeds and can create their own schedule of payments at that time.
The insurance company issues the policy and has to honor the promises in it. Guarantees in the policy are only as good as the financial ability of the insurance company to pay claims.
What Are Non-Qualified Variable Annuities?
Non-qualified variable annuities are personally owned and paid for with after-tax dollars. They aren't part of any IRA or pension plan and don't have any limits on contributions.
Non-qualified variable annuities have three key tax benefits:
- Tax-deferred growth: No tax is paid on the growth, capital gains, or dividends of the subaccounts until money is taken out.
- Tax-free transfers between subaccounts: There is no tax for transferring between subaccount investments.
- Tax-favored income: Income from an annuity option is partially taxable.
Also, the income you receive from non-qualified variable annuities is taxed at ordinary income rates.
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Why Buy a Non-Qualified Variable Annuity?
Non-qualified annuities are a popular, flexible, retirement planning tool. They can be used to accumulate money and provide a supplemental retirement income.
The tax benefits and unlimited contributions make them attractive for investors who have maxed out their IRA or pension contributions. Investors can also use non-qualified annuities to protect a portion of retirement savings from market downturns.
Among the benefits of non-qualified annuities are:
- Lifetime income: Variable annuities have lots of options for lifetime guaranteed income. Options include income for the lifetimes of two people, called joint and survivor.
- Money management tool: For some investors who “rebalance” their portfolios between stocks, bonds, and cash, the tax-free transfer between subaccount investments is an attractive feature.
- Market protection: Variable annuities have features called living benefits that guarantee a minimum lifetime income regardless of market performance. Some variable annuities, called indexed variable annuities, offer a level of protection against market losses. The investor selects a percentage of downside protection, 10% and 20% are common. The insurance company absorbs losses in the account up to the selected percentage. In exchange, the growth in the account is limited or capped by the insurance company.
What Are Qualified Variable Annuities?
Qualified annuities are part of pension plans or IRAs. Traditional IRAs are paid for with before-tax dollars. Roth qualified annuities are paid for with after-tax dollars.
Qualified annuities are included in the contribution limits of pension plans and IRAs. There is no tax benefit to buying a qualified annuity. Pensions and IRAs already offer tax-deferred growth and tax-free transfers between investments.
Why Buy a Qualified Variable Annuity?
If you have an IRA or pension plan, you already have the benefits that annuities offer like tax-deferred growth and tax-free transfers between investments. Why pay fees for something you already have? And the answer is you wouldn't unless you were getting close to retirement or really worried about losing money.
If you're getting close to retirement, you are probably thinking about a lot of things. Wahoo! I don't have to go to the office! You might also be thinking about your retirement money and how to get income from it. That's what annuities are for. They can guarantee income for the rest of your life.
If you're really worried about down markets (think 2008 to 2009), variable annuities can offer some protection. Variable indexed annuities and variable annuity living benefits offer growth and protection from losses.
How Are Qualified and Non-qualified Variable Annuities Taxed?
Qualified and non-qualified annuities are treated differently for tax purposes. The chart below is a summary.
| Non-qualified | Qualified | Qualified/Roth | |
| Contributions | After-tax, unlimited | Pre-tax, limits for IRAs and qualified plans apply | After-tax, limits for IRAs and qualified plans apply |
| Growth | Tax-deferred | Tax-deferred | Tax-deferred |
| Surrender | Gain is taxed at ordinary rates | All proceeds taxable | Tax-free |
| Annuity Income | Partially taxable at ordinary rates | 100% taxable at ordinary rates | Tax-free |
| Withdrawals | Withdrawals are gain first, gain is taxed at ordinary rates | 100% taxable at ordinary rates | Tax-free |
| Loans | Loans are considered withdrawals, gain first is taxed at ordinary rates. | IRA loans not permitted, pension plans may have exceptions for home purchase and loans repaid in five years | IRA loans not permitted, pension plans may have exceptions for home purchase and loans repaid in five years |
| Death Benefits | Gain is taxed at ordinary rates, proceeds will be taxed as "gain first" | Rules for inherited traditional IRAs and qualified plans apply | Rules for inherited Roth IRAs and plans apply |
| Sales | Proceeds in excess of basis taxed at ordinary rates. | N/A | N/A |
| Penalties | 10% for withdrawals before age 59 1/2 | 10% for withdrawals before age 59 1/2 | 10% for withdrawals before age 59 1/2, penalty for withdrawals prior to end of the fifth year |
The big picture — if you didn't pay taxes on the money going in, you pay taxes on the money coming out.
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What if the Insurance Company Goes Bankrupt?
Insurance companies are regulated by state insurance departments. The insurance company has to meet financial standards and report on their condition.
Each state has a guaranty fund to protect consumers if an insurance company can’t meet its obligations. Variable annuities are separate accounts of the insurance company, and they are not subject to creditor’s claims. The variable annuity separate accounts are regulated by the SEC.
Financial strength ratings of insurance companies are available from A.M. Best, Fitch, Moody’s and Standard & Poor. The rating each service assigns reflects their opinion on the insurance company's ability to pay claims.
Look for high quality ratings from at least two of the four. The chart below summarizes the financial strength ratings of the different services.
| Highest Ability to Meet Obligations | Medium Ability to Meet Obligations | Lowest Ability to Meet Obligations | |
| A.M. Best | A++ to A- | B++ to B- | C++ to C- |
| Moody’s | Aaa to Aa | A to Baa | Ba to Caa |
| S&P | AAA to A | BBB to B | CCC to C |
| Fitch | AAA to AA- | A+ to BBB- | BB+ to CC |
Variable Annuities and Your Retirement Plan
Variable annuities can be an important part of your retirement plan. they're a flexible and powerful financial tool, but they're not for everyone.
A professional independent insurance agent's job is to make things simpler and save you time. They can help you decide if a variable annuity is right for you.