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Qualified vs Non Qualified Annuities

What are the differences?

 

QUALIFIED versus NON-QUALIFIED FUNDS

The IRS looks at funds in terms of qualified or non-qualified, in order to determine that money's taxability.

 

Qualified is just IRS language for funding with pre-tax dollars, meaning the contribution itself could qualify for a tax deduction, lowering taxable income. When you take a distribution from a qualified annuity for example, the entire distribution amount (contributions and earnings) is subject to ordinary income taxes.

 

Non-qualified is funding with after-tax dollars, meaning you have already paid taxes on the money before it goes into the retirement plan. When you take money out, only the earnings are taxable as ordinary income.

Congress authorized tax qualified accounts to encourage retirement savings. They do this by offering tax breaks of various kinds to savers. The Employee Retirement Income Security Act of 1974 -- ERISA -- put in place the framework for tax-qualified retirement plans. ERISA is the umbrella law covering the rules and regulations of all types of tax-qualified retirement plans.

What is a Qualified Annuity?

A qualified annuity is simply an annuity funded with pre-tax dollars, 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.

What is a Non-Qualified Annuity?

Annuities purchased with after-tax money are taxable upon withdrawal, but unlike a qualified annuity, only the earnings are taxed. Your funds grow on a tax-deferred basis, so you will not owe taxes on the income and investment gains from an annuity until your withdrawals begin.

Comparing Qualified and Non-qualified Annuities

Here is a more complete list of the similarities and differences between qualified and non-qualified annuities:

Deposits into qualified plans result in an income tax deduction, but limits exist regarding maximum contributions. Money accumulates without tax liability until it is withdrawn.

 

It is important to note that the money placed in Qualified accounts must be earned income.

 

Limits

 

Qualified plans are subject to annual contribution limits set by the IRS each year. Contributions in excess of these amounts are not deductible and may subject the employee to excise taxes. In contrast, contributions to non-qualified plans are unlimited.

 

Qualified accounts do not allow you to take your money until you are age 59 ½. If the account holder does so, it is standard procedure that the IRS will take 10% of the account's value, and the account is still subject to normal taxation after that point (as yearly income).

 

One drawback for investors is that income taxes are typically higher than capital gain taxes. The IRS views all income taken from qualified accounts as income for that year, and thus, is taxed at a higher percentage than it would be as a capital gain.

Some Examples of Qualified retirement plans:


401(k)s;
403(b)s;
Thrift Savings Plans (TSPs);
Simplified Employee Pensions (SEPs);
Traditional IRAs; (Technically, IRAs aren't qualified plans, because they aren't offered by employers. Nevertheless, in considering the tax consequences, it makes sense to treat them in the same way as qualified plan accounts, because the tax deferral and deduction features are similar.)

A non-qualified retirement plan is one that does not meet IRS criteria for deducting contributions on your income taxes.

 

Deposits into non-qualified retirement vehicles still accumulate without tax liability, but only the portion of each withdrawal that's considered earnings is fully taxable. Non-qualified investments have the same age restrictions as their qualified counterparts, and taxable distributions before age 59 1/2 usually result in a 10 percent penalty.

 

There are no limitations or restrictions on how much money you can contribute to non-qualified accounts.

 

Non-qualified plans are typically supplemental benefits on top of those provided by a company's qualified retirement plans. They are not required to meet ERISA standards regarding eligibility, participation, documentation and vesting. Non-qualified plans are often used as an added incentive for executives and other highly compensated employees.

Non-qualified Tax Advantages

  • An additional income stream when you retire
  • Earnings grow tax deferred until withdrawn.
  • Longer age limits on contributions
  • No Required Minimum Distributions at age 70½

Non-Qualified Tax Consequences

A nonqualified plan operates much the same as a qualified plan for the benefit of the owner. As long as the individual is neither in constructive receipt of nor derives any economic benefit from the benefits or contributions accumulated under the plan, federal income tax (and generally state or other income tax) is not assessed. Contributions provided and interest or investment income on the contributions or benefits accruing under a nonqualified plan do not create a current tax liability rather the individual pays taxes on the benefit received at the time of actual receipt of the plan funds.

Retirement Considerations

You also need to consider how you will receive your non-qualified annuity proceeds at retirement. Typically, annuitants do this in one of three ways:

  • A lump sum payment – could result in significant tax liability, especially if it moves you into a higher tax bracket
  • Fixed payments for life
  • A fixed amount for a certain period of time

 

Here are some of the main differences between qualified and nonqualified plans:

Qualified Annuities Non-qualified Annuities
Tax-deferred contributions and earnings Tax-deferred earnings
Penalty for early withdrawal Penalty for early withdrawal
Invest pre-tax dollars Invest after-tax dollars
Individual must have earned income No earned income requirement
IRS Contribution limits No IRS contribution limits; WoodmenLife limits contributions to $25,000 per year.
In most cases, withdrawals must begin by age 70½ No federal withdrawal rules, but there could be state laws

Plan Feature

Qualified Plan

Nonqualified Plan

Eligibility

Must be available equally to all employees as defined by the plan

Can be made available only to select employees

Compensation deferral limits

Yes; total dollar limits are adjusted each year by the IRS; pre-tax maximum for 2014 was $17,500

No IRS-defined limits

Distribution timing

Generally, cannot take distributions before age 59½ except for certain financial hardships

Several options available but once a distribution option is elected, it cannot be changed; Section 409A restrictions apply

Mandatory distributions

Yes; must take Required Minimum Distributions starting at age 70½

Not required by IRS but plan rules may apply

Assets protected from company creditors

Yes

No

Loans

Yes, if the plan allows

No

Participant and company tax deduction on deferrals

Yes, in the year of deferral

Yes, but not until distribution

Rollover to IRA upon job loss

Yes, under terms of the plan

No

 


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