Qualified annuities are funded with pre-tax income and established through an employer’s pension plan, while non-qualified annuities are funded with after-tax income and have no contribution limits. Both have tax rules and illiquidity concerns, so it’s important to diversify investments.
A qualified annuity is an annuity that is funded with pre-tax income. Qualified annuities are generally established through an employer as part of a pension plan that is designed to provide income to employees after retirement. With a non-qualified annuity, the funds to create the annuity come from after-tax income. The tax rules for qualified and nonqualified annuities are different, and it’s important to know how they work when setting up an annuity so you can make the best decision.
With a qualified annuity, employers set up a pay reduction plan, in which workers agree to give up part of their salary to fund an annuity. Each paycheck will show the amount contributed to the annuity as a debit against the employee’s salary that reduces the amount of money the employee earns. Because the money is withdrawn on a pre-tax basis, it is not taxed at the time it is earned, and can count as a tax deduction to reduce an employee’s taxable income.
Once the annuity expires, the employee begins receiving payments. Each payment is taxable, and individuals pay taxes on the principal and earnings of the qualified annuity. With a qualified annuity, employees can also cash in the annuity early, if they are willing to pay a surrender fee and lose some of the money retained in the annuity. In the event of the annuity’s death, the funds will be sent to the annuity beneficiary, assuming one was established when the annuity was established.
The benefit of a qualified annuity is that it reduces tax liability while someone is working and establishes a retirement fund for someone to have a source of income after retirement. The downside is that total contributions are usually capped, people will have to pay taxes when the funds are released, and the funds are also locked in the annuity until it matures. For this reason, relying on a qualified annuity solely as a savings and investment vehicle is not advisable. Instead, money should be invested in various places, preferably providing some liquidity so that people are prepared in the event of a financial emergency.
People who choose to buy non-qualified annuities are not taxed on the principal, because the principal comes from after-tax income. They pay taxes on the earnings of the annuity. Non-qualified annuities also lack contribution limits, since individuals contribute as much money as they want and individuals can set them independently instead of turning to employers. However, the same illiquidity associated with a qualified annuity is present with a nonqualified annuity.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
