Annuities are probably the most complex “beast” in the financial world. As if it isn’t enough, life insurance companies multiplied product varieties to make sure they are the only ones who can understand (and sell!) annuities.
One of the most fundamental concepts to understand is the qualified vs non-qualified annuity. At first glance, I would be tempted to select a qualified annuity without any doubts. The term “qualified” inspires trust. In the financial industry, trust is everything.
But if you are like me and selected the qualified annuity right off the bat, you would make a big mistake. In fact, non-qualified annuities show a better tax treatment than qualified annuities!
What the Term Qualified is All About
The term “qualified” for an annuity denotes if the annuity is purchased with money coming from a pension plan / registered account or from after-tax money or a taxable savings account. Many retirement plans across the world enable you to buy an annuity at retirement. During your working years, a part of your salary is deposited and invested in a tax-sheltered account. Upon retirement, you often have the option of either investing the money as you wish in your own retirement account or purchasing an annuity. The annuity will give you a fixed payment for the rest of your life. This is how defined pension plans work as well.
This is what we call a qualified annuity. The money used to buy the annuity is coming from a tax-sheltered account. Therefore, each annuity payment is fully taxable and can be calculated using a free tax estimator. It is being added onto your income at the end of the year and is taxed as a salary. Therefore, if you live in a country where the marginal tax rate tends to increase fast, your annuity payment may be sponsoring both your retirement and the government at the same time!
On the other hand, you don’t need a registered account or a pension plan to buy an annuity. You can buy one using your own funds. The money used to buy the annuity coming from your bank account. This also means you have already paid taxes on this money prior to buying the annuity. But since you already paid taxes on that money, we call it a non-qualified annuity as it doesn’t “qualify” as money coming from a pension plan. The good news about the “non-qualification” is you pay fewer taxes on your annuity payment!
A part of the annuity payment is considered to be a “return of capital” meaning the insurance company gives you back a part of the after-tax money you use to purchase the annuity contract. This is why, usually, the non-qualified annuity rate is better than the interest paid by a bond or a certificate of deposit. While interest payments are fully taxed (as income), the non-qualified annuity payment include a part that is tax free.
The Best Resources to Understand a Non-Qualified Annuity Tax Treatment
I’ve been searching the web for an easy to understand example that would teach you how the tax treatment works for both type of annuity. I found this website; Annuity Rates HQ that wrote a whole article explaining what a non-qualified annuity is.
You will find an example with real numbers along with a 20min length video going through the whole process. It’s easy to understand and it is definitely a financial strategy that works!