Nonqualified Annuity

A nonqualified annuity is an annuity contract purchased with after-tax money, held outside of an employer retirement plan or an IRA. The label refers to the contract's tax status, not to its design: a nonqualified annuity can be immediate or deferred, and fixed, variable, or indexed.

The contrast is with a qualified annuity: the same kind of contract, but purchased inside a traditional IRA or an employer plan with pre-tax or tax-deferred dollars. Because a qualified annuity's entire value was never taxed going in, withdrawals from it are fully taxable as ordinary income under Internal Revenue Code Section 72, with no tax-free portion at all. A nonqualified annuity, by contrast, was funded with money that already paid income tax once, so only the growth is taxed on the way out.

That distinction drives how withdrawals are taxed before the contract is turned into a stream of payments (annuitization fixes the date that changes this — see annuitization). Under Section 72(e), a withdrawal from a nonqualified deferred annuity is treated as coming from earnings first: last-in, first-out, so taxable growth is treated as withdrawn before any tax-free return of premium. Only once all the gain has been withdrawn does further money out count as a tax-free return of the original premium, the reverse of how a Roth IRA returns contributions first.

A withdrawal of taxable gain before age 59½ generally triggers a 10% additional tax under Section 72(q), on top of ordinary income tax on the gain, subject to exceptions such as death, disability, or a schedule of substantially equal periodic payments.

A nonqualified annuity also escapes the lifetime required minimum distribution rules that apply to a traditional IRA: because the money was never tax-deferred going in, there is no RMD obligation forcing withdrawals to begin at a set age. Post-death distribution rules still apply, though, governed by the contract and Section 72(s), not by the account owner's estate plan.

One consequence rarely appreciated: the gain inside a nonqualified annuity does not get a step-up in basis when the owner dies, unlike many other inherited assets. It passes to the beneficiary as untaxed gain that remains taxable when withdrawn, income in respect of a decedent, so an inherited nonqualified annuity is not the tax-free windfall an inherited house or brokerage account with a stepped-up basis can be.

A hypothetical example: Elena puts $100,000 of after-tax savings into a nonqualified deferred annuity. Ten years later the contract is worth $160,000, made up of her $100,000 original premium and $60,000 of gain. If she withdraws $60,000, the entire amount is taxed as ordinary income under the LIFO rule (and, if she is under 59½, also hit with a 10% additional tax on that $60,000). Only a withdrawal beyond $60,000 would begin returning her $100,000 basis tax-free.

Pros

• No annual dollar contribution limit, unlike an IRA or 401(k), which makes it one way to keep deferring tax on savings after other tax-advantaged accounts are full.
• Growth compounds tax-deferred until withdrawn.
• No lifetime RMDs force money out on a schedule the owner doesn't control.

Cons

• Withdrawals of gain are taxed as ordinary income, not at lower long-term capital gains rates, even if the underlying investments would have qualified for those rates held outside the annuity.
• No basis step-up at death; the gain remains taxable to whoever inherits the contract.
• The 10% additional tax on gains withdrawn before 59½ reduces flexibility for money that might be needed early.