Retirement Planning

qualifying annuity

What is a qualifying annuity?

A qualified annuity is similar to any other annuity, but the IRS has approved it for use in a qualified retirement plan or individual retirement account (IRA). These annuities can be fixed, indexed, or variable, depending on the plan sponsor’s investment goals. Contributions to qualifying annuities are tax-deductible, unless the plan or annuity has Roth functionality, according to Employee Retirement Income Security Act (ERISA) guidelines.

key takeaways

  • A qualified annuity is an annuity approved by the IRS for use in an IRA or qualified retirement plan, similar to other types of annuities.
  • Qualifying annuities can be variable, fixed, or indexed.
  • Withdrawals from annuities before age 59½ are subject to a 10% penalty.
  • However, because the ineligible annuity is purchased with after-tax dollars, only the income is penalized.

How Qualified Annuities Work

Qualifying annuities are not tax-exempt plans per se; they must reside in a qualifying plan or IRA to enjoy this status. A qualified annuity can be the only instrument in the plan or account, or it can be one of several other options offered.

In many cases, the qualifying annuity is a variable contract, the only instrument offered within the plan, and variable sub-accounts constitute an option available to plan participants.

There are many types of annuities to choose from, depending on factors ranging from retirement income needs to financial risk tolerance.

Type of annuity

pass and fail

The products that go into qualifying and non-qualifying annuities are the same. However, the rules for ineligible annuities are different and are described in IRS Publication 575. A twist is that when part or all of a ineligible annuity is refunded, the first money is considered income for tax purposes and is therefore taxed at ordinary income levels. Once all income has been withdrawn, the remaining money – the original investment – can be withdrawn tax-free.

If payments under a ineligible plan are made as recurring payments, a portion of each payment will be considered a return on the original investment without tax. Some expenses are considered income and taxed at ordinary income rates. The exact percentage of benefit to principal depends on the type of payment and the age of the beneficiary.

fixed and variable

Annuities can often be structured as fixed or variable. A fixed annuity provides regular periodic payments to the annuity beneficiary. A variable annuity allows the owner to receive more future cash flow if the investments within the annuity fund perform well and pay less if their investments perform poorly. This provides less stable cash flow than a fixed annuity, but allows the annuity beneficiary to earn a good return on the investment in their fund.

special attention items

There are many other considerations, including selling expenses, commissions, and annuity terms. Withdrawals before age 59½ are subject to a 10% penalty regardless of annuity eligibility. Since non-qualified annuities are purchased with after-tax dollars, only income is penalized.

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