Taxation of Qualified and Non-Qualified Annuities

Annuities may also be classified as either “qualified” or “non-qualified.”

This distinction is critical to understanding how annuities are used in retirement and how they are taxed.

Simply stated, a non-qualified annuity is one purchased with money that has already been taxed. A qualified annuity is purchased with money which has not yet been taxed as income.

Why is this important?

First, we need to delve into qualified retirement plans to set the stage for discussing qualified versus non-qualified annuities. The difference is not in the annuity policy itself, rather it is how the tax laws affect the amount that can be deposited, when and how much must be taken out, taxes and tax penalties.

Employee retirement plans qualify for certain tax advantages by being offered to all eligible employees, not just to a select few. Employers, by starting and funding a qualified retirement plan, receive current tax deductions for contributions made on behalf of the plan participants. Employees typically are not taxed on these qualified plan contributions at the time they are made by the employers. As additional deposits are made from each paycheck, these funds continue to grow and accumulate over time on a tax-deferred basis. Qualified plan account values continue tax-deferred growth while the employee is still working.

At retirement, qualified plan distributions become taxable income to the retired workers. Rules for qualified plans are generally found in Section 401 of the Tax Code. While the plan has an administrator, typically the plan assets are held by a trust company or custodian bank.

There are seven common types of qualified plans:

Profit Sharing Plans (which includes both 401(k) and Roth 401(k) plans)
Stock Bonus Plans
Money Purchase Pension Plans
Employee Stock Ownership Plans (ESOPs)
Defined Benefit Plans
Target Benefit Plans
Plans for Self-Employed Individuals (Keogh Plans)
Other Plans:

Individual Retirement Accounts (IRAs)
Roth IRAs
403(b) and 457 Plans
Simplified Employee Pension Plan (SEP-IRAs)
SIMPLE IRAs

Defined Benefit Plans, also known as pensions, were an important fringe benefit after World War II when employers were strictly limited by law concerning the pay raises they could provide employees. From 1945 – 1970, participation in private pension plans increased from approximately 19% of the workforce to about 45%.

What is “defined” in a defined benefit plan?

The benefit is defined; the monthly amount the retiree will receive is calculated by the plan.

The pension benefit is determined by a formula and typically paid in the form of a lifetime annuity. This is a use of the classic definition of an annuity, not normally applied to private pensions or a commercially available product. Payment calculations vary. If calculated on a dollar amount per month for each year of service, this is what it would look like:

Defined Contribution Plans

Since the 1960s, the popularity of defined benefit plans has diminished. Although pension plans are still around and new defined benefit plans are being added each year, the rapid growth and wide acceptance of defined contribution plans have outpaced pension plans. The clear trend is that defined contribution plans are currently growing faster than defined benefit plans.

The 401(k) is the Most Widely Used Defined Contribution Plan

It allows employees to defer a portion of their current income in a pre-tax savings account with the convenience of a payroll deduction. 401(k) plans must follow strict regulation concerning how much the highly compensated employees (usually business owners and key managers) may contribute compared to the non-highly compensated employees (rank and file workers).

Employer Matching

In some defined contribution plans, management will match employee contributions up to a certain dollar amount or percentage of employee income. This tends to increase rank and file employee participation – think “free money.” This incentive provides an additional benefit for the highly compensated employees (typically the owners, or managers of the business) by allowing a higher level of participation and tax-deferred accumulation in the plan.

Portability

Portability is another advantage of 401(k) plans. For employees who change jobs, the ability to rollover 401(k) account values into a new employer’s plan may offer the possibility of continuous growth. Even if a new employer’s plan is not set up to receive money from a previous employer, the employee may rollover his/her 401(k) account to an IRA and continue the tax-deferred accumulation until retirement.

Investment Choice

Many employees in 401(k) plans enjoy selecting investments. Plans usually have a menu of ten to thirty mutual funds to choose from. Employees may reallocate investments among the various choices via telephone or computer access to their accounts.

Employee investment choice has a distinct disadvantage. The employee bears 100% of the risk. During good times in the stock market when growth is positive, employees are usually happy about their selections. During bad years in the stock market when growth is negative and values drop, employees have no company back up and no safety net, other than the more conservative investment choices in the plan such as a money market or stable value account, or perhaps a bond account.

After Employment

When an employee departs from the employer and continues to leave the funds in the old employer’s plan, frequently the management fees which were paid by the former employer become a new expense to the ex-employees 401(k) investment. A rollover to an IRA or new plan eliminates this expense.

Loans

Some plans include loans as a part of the 401(k) plan, which may allow employees to borrow up to half of the account value, up to a maximum of $50,000. These loans must be paid back according to a definite schedule; otherwise the loans are considered current income and are taxable with 10% penalties (if younger than age 59½) added to the current taxes due.

Despite the popularity of 401(k) plans, most employees are currently unaware of a major issue that most plans have. In a majority of cases, existing defined contribution plans do not have a mechanism for taking withdrawals at retirement. Most plans suggest that participants rollover their account balance at retirement to an Individual Retirement Account (IRA). There are no guarantees that either required minimum distributions or systematic withdrawals from mutual funds will provide adequate retirement income for the retiree’s life.

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