Non-Qualified Tax-Deferred Annuities Can Help Strengthen Your Clients’ Retirement

The focus of this discussion will center around annuity contracts held outside of IRAs, 401(k) and 403(b) plans or other tax-qualified retirement plans (tax-qualified plans), also referred to as non-qualified annuities. In general, the tax treatment of annuities held in IRAs and other tax-qualified plans is governed by the tax status of those plans.

Some advisors recommend that their clients max out other tax-deferred investment plans, such as 401(k) 403(b) plans or traditional IRAs before considering annuities as part of their portfolios. Each client’s situation is different therefore this may not apply to everyone.

Advisor discussions with clients on how their portfolio should be structured is very different for each client, depending on their short and long-term investment goals, income needs, and financial situation, but non-qualified annuities also have advantages to supplement other retirement vehicles, in terms of accumulation, contribution limits, and age requirements.

Non-qualified annuities are taxed in different ways, depending on the type of annuity your clients hold. There are several Federal Income Tax Rules associated with how these annuities are taxed. Outlined below are a few key insights for discussion, however it is always advised that clients seek a tax consultant regarding Federal taxation of annuities.

• Non-qualified annuities are funded with after-tax dollars, and so only a portion of payouts is taxed.
• Non-qualified annuities are generally categorized as immediate or deferred annuities. Immediate annuities are taxed as part principal and part earnings whereby deferred annuities can be taxed as a ratio of earnings and principal.
• The client’s investment grows on a tax-deferred basis during the accumulation phase, until withdrawals or annuitization begin.
• Money can be taken out of a non-qualified annuity in two ways, but each are taxed differently.
• Withdrawals, dividends, loans, or surrenders are taxed on a last in, first out (LIFO) basis, meaning that earnings and interest are taxed first as ordinary income. Once earnings and interest are depleted, everything else is generally income tax free. If a client makes a withdrawal before the age of 59½, there could potentially be a 10% premature withdrawal penalty.
• With annuitized payments, the portion of each payment subject to income tax is determined by an exclusion ratio of earnings to principal, and every contract has a different ratio depending on a number of facts, such as age and life expectancy.
  
  
  

Non-qualified annuities have several significant benefits that may help improve the tax efficiency of your client’s portfolio:

Tax deferred growth
Clients won’t pay income taxes on gains they accrue during the accumulation phase of their annuity until withdrawn. This means more money remains in the account with the potential to grow.

No contribution limit
Unlike 401(k) plans or IRAs, there are no specific IRS contribution limits on non-qualified annuities, however insurers may set maximum contribution limits for their products. Having no IRS contribution limit can be helpful for clients who have already maxed out other financial instruments and are seeking further tax deferral opportunities.

Flexible accumulation
A non-qualified annuity offers multiple ways to save into it. Savings can either be built up over an accumulation phase (deferred) or purchased immediately (immediate), giving your clients flexibility as they plan for retirement.

No minimum age for distributions
There’s no minimum age at which your clients are required to begin withdrawing their money. 401(k) plans and other tax-qualified retirement accounts, clients are generally required to start withdrawals no later than age 70½. Note that withdrawals from an annuity made before age 59½ may incur a 10% federal tax to the taxable amount of earnings withdrawn in addition to any income tax that may be due.

While non-qualified annuities, along with optional riders, have recently become better known for providing the benefits of guaranteed income for life and potential downside protection from the equity markets, they also offer significant tax benefits. When a non-qualified annuity is used together with other tax efficient products as part of your client’s overall investment strategy, your clients can improve their overall long-term portfolio performance by taking advantage of tax-deferred growth.

To better understand different types of annuities and related terms, download our
Quick and Easy Guide to Annuity Terminology.