Annuities are definitely complex and their understanding comes with a few hours of researches along with learning new terminology. Another term you can hear from your adviser when discussing annuities is “qualified” vs “nonqualified”. While immediate and deferred annuities relate to the timing of your payments, the terms qualified and nonqualified are linked to the source of money used to purchase the contract. More precisely, the term used is directly linked if you have used savings from your tax-deductible IRA or any other employer-sponsored retirement plan to buy the annuity. The different between the two types of annuities are fairly significant.
A qualified annuity is purchased with money coming from a tax-deductible savings account such as an IRA or other employer-sponsored pension plan. The tax implication is crucial. Any annuity payments are subject to taxes. As opposed to regular annuity distributions which are only partially taxable, qualified annuities payments are fully taxable.
Many investors don’t want to bother with stock market fluctuations at retirement and prefer cashing their IRA’s to buy a qualified annuity where the stream of income is guaranteed. At that point, you lose control of your investment but receive a determine amount monthly instead.
At the age of 70 ½, a required minimum distribution (also called RMD) is applied on all IRA’s and other retirement account. This rule has been put in place so the Government receives taxes from your pension plan. The RMD rule applies also to qualified annuities. Therefore, if you think of avoiding taxes by switching your IRA account into a qualified deferred annuity, you will not pass the age of 71 without withdrawing at least the RMD and pay taxes on it.
Taxes apply as any other type of income on such contract. The annuity payment is added to your revenue declaration.
As opposed to qualified annuities, nonqualified annuities regroup all contracts purchased with after-tax money. The main advantages of nonqualified annuities are the possibility to defer future taxed (through deferred annuities) and the tax efficiency on payments. In fact, annuity payments are partially taxable as a part of the distribution is considered to be a return of capital. Since you have paid taxes on the money used to buy a nonqualified annuity, it is only normal to not be double taxed.
What’s the Best Between a Qualified and Nonqualified Annuity?
Depending on your revenues and sources of income at retirement, you may or may not have the option to purchase one or the other. But if you have an amount in cash and you also have in an IRA type of account, you can certainly benefit from the nonqualified annuity tax efficiency since the money invested in your pension account is already tax-sheltered.
If you use your tax-sheltered money to purchase an annuity, your distribution will not only be fully taxable but you cash invested in other products will be taxable too. Therefore, it is preferable to use cash to buy an annuity in a tax perspective. Keep in mind that if you require lump sum withdrawals, you might not want to invest all your cash in an annuity.