What Is a Qualifying Annuity?
Let me explain what a qualifying annuity is—it's basically like any other annuity, but the IRS has given it the green light for use in a qualified retirement plan or an individual retirement account (IRA). You can find these in fixed, indexed, or variable forms, depending on what the plan sponsor aims for in terms of investments. Under the Employee Retirement Income Security Act (ERISA) rules, the contributions you make into one of these are tax-deductible, except if the plan or annuity includes a Roth feature.
Key Takeaways
Here's what you need to remember: a qualifying annuity is one the IRS approves for an IRA or qualified retirement plan, and it's similar to other annuities out there. It can come as variable, fixed, or indexed. If you withdraw from an annuity before you're 59½, expect a 10% penalty. But with a non-qualified annuity, since it's bought with after-tax dollars, only the earnings get hit with that penalty.
How a Qualifying Annuity Works
Qualifying annuities aren't tax-deductible on their own; they have to be inside a qualified plan or IRA to get that benefit. They might be the only option in the plan or account, or just one among several. Often, you'll see them as variable contracts, especially if that's the sole vehicle in the plan, with the variable subaccounts giving participants their investment choices.
Important Note on Annuity Types
You should know there are plenty of annuity types to pick from, based on things like your retirement income needs or how comfortable you are with financial risk.
Types of Annuities
When it comes to qualified and non-qualified annuities, the products inside them are the same, but the rules differ—check IRS publication 575 for the non-qualified side. One key difference is that if you partially or fully surrender a non-qualified annuity, the first money out counts as earnings and gets taxed at ordinary income rates. Once you've pulled all the earnings, the rest—your original investment—comes out tax-free.
If you're taking payments from a non-qualified annuity as periodic payouts, part of each one is seen as a return of your original investment, so no taxes on that, while the earnings portion gets taxed at ordinary rates. The split between earnings and principal depends on the payout type and your age as the beneficiary.
Fixed and Variable Annuities
Annuities generally fall into fixed or variable structures. With a fixed annuity, you get regular periodic payments as the annuitant. Variable annuities let you potentially get bigger future cash flows if the investments in the annuity fund perform well, but smaller ones if they don't—this means less stable cash flow than fixed, but you can benefit from strong investment returns.
Special Considerations
There are other factors to consider, like sales fees, commissions, and the annuity's duration. No matter if it's qualified or not, withdrawing before 59½ triggers a 10% penalty. For non-qualified annuities, bought with after-tax money, only the earnings face that penalty.
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