Annuity is an investment from which periodic withdrawals are made. To invest in an annuity, an investor should have a large sum of money to be invested at once and withdrawals will be made over a period of time. Annuities can be divided into two main categories as qualified and non-qualified. The key difference between qualified and non-qualified annuity is that qualified annuity is an annuity that is eligible for tax deduction whereas non-qualified annuity is an annuity that is not eligible for tax deduction as the investor have already paid taxes on the fund at its inception.
CONTENTS
1. Overview and Key Difference
2. What is Qualified Annuity
3. What is Non-qualified Annuity
4. Side by Side Comparison – Qualified vs Non-qualified Annuity
5. Summary
What is Qualified Annuity?
Qualified annuity is referred to as an annuity that is eligible for tax deduction. According to Internal Revenue Service (IRS), when a distribution is made to annuity, it is subject to income tax. Since qualified annuity offer accumulates tax-deferred earnings and has attractive tax advantages, they are considered as an attractive investment option.
Given below are some examples of qualified annuities.
Individual Retirement Account (IRA)
With an IRA, the investor invests a certain amount of money for retirement savings in an account set up through investor’s employer, a banking institution or an investment firm. In IRAs, funds are dispersed into different investment options to generate a return. There are two main types of widely used IRAs: Traditional IRA and Roth IRA.
Traditional IRA
In this, the funds are not taxed until withdrawn. If the funds are withdrawn before the end of the retirement period, 10% penalty charge is payable to the insurance company. If the tax rate at the end of the retirement is lower, this is more advantageous.
Roth IRA
In Roth IRA, the annual contributions are made with the after tax funds. There will be no tax charge at the withdrawal in retirement; therefore, if the tax rates are higher at the time of retirement, this option is more beneficial compared to traditional IRA.
401 (k) plan
401(k) plan is an investment plan established by employers to make salary deferral contributions for eligible employees on a pretax basis.
403 (b) plan
403(b) plan is a retirement plan similar to 403 (b) for employees of public schools and tax exempt organizations. This is also referred to as Tax Sheltered Annuity (TSA) plan.
Figure 01: 401 (k) is one of the widely used qualified annuities
What is Non-qualified Annuity?
Non-qualified annuity is an annuity that is not eligible for tax deduction as the investor has already paid taxes on the fund at its inception. Only the earned interest is taxable in a non-qualified annuity when the interest is withdrawn. If the investor decides to withdraw the principal amount, then taxes would not be due on the same. Given below are some examples of non-qualified annuity.
Stocks
Stocks are investments that represent ownership in a company. Common stocks and preference stocks are the main types of stocks. Common stockholders are entitled to voting rights while preference stockholders are not.
Mutual Funds
A mutual fund is an investment vehicle where funds are pooled from a large number of investors who share a mutual investment goal. A mutual fund is managed by a fund manager who makes investments in a number of options such as stocks, bonds and money market instruments with the intention of making capital gains.
What is the difference between Qualified and Non-qualified Annuity?
Qualified vs Non-qualified Annuity |
|
| A qualified annuity is referred to as an annuity that is eligible for tax deduction. | Non-qualified annuity is an annuity that is not eligible for tax deduction. |
| Opposite | |
| A qualified annuity is a pretax investment. | Non-qualified annuity is a post-tax investment. |
| Examples | |
| IRAs, 401 (k) and 403 (b) plans are popular examples for qualified annuity | Stocks and mutual funds are widely used non- qualified annuities. |
| IRS Limitations | |
| IRS limits annual contributions for qualified annuity. | IRS limitations of annual contributions are not applied for non- qualified annuity. |
Summary- Qualified vs Non-qualified Annuity
The key difference between qualified and non- qualified annuity depends on whether the annuity is eligible for tax deduction (qualified annuity) or not eligible for tax deduction (non- qualified annuity). Both these types of annuities have a 10% penalty for early withdrawal if the investor is below the age of 59.5 years. Furthermore, investors must begin to take contributions once they reach the age of 70.5 years irrespective of whether the annuity is qualified or non- qualified.
Reference:
1.” Qualified and nonqualified annuities.” Ameriprise Financial. N.p., n.d. Web. 22 May 2017. <https://www.ameriprise.com/research-market-insights/financial-articles/investing/qualified-nonqualified-annuities/>.
2. Douglas MacDonald, Account Executive Performance Marketing and Analytics Follow. “Your Path to Financial Security.” LinkedIn SlideShare. N.p., 31 Aug. 2015. Web. 22 May 2017. <https://www.slideshare.net/djmacdonald/your-path-to-financial-security>.
3. “How Is My Annuity Taxed?” Annuity 123. N.p., 04 Sept. 2014. Web. 22 May 2017. <http://blog.annuity123.com/how-is-my-annuity-taxed/>.
Image Courtesy:
1. “401k-historical-chart” By BlairSnow – Own work (CC BY-SA 3.0) via Commons Wikimedia