Tax Rules on Nonqualified Annuities

by Gregory Gambone, studioD

Annuities are retirement investment vehicles maintained by life insurance companies. If you invest in a non-qualified annuity, you may contribute as much money as you want and any growth in the account remains untaxed until you withdraw it. Specific tax legislation exists detailing the time, manner and amount of the taxes due on distributions from these accounts.

Non-Qualified Annuities Explained

Non-qualified annuities allow investors to save an unlimited amount of money for use during retirement. Money accumulates without tax liability until it is withdrawn, allowing more of your savings to be invested than money in an ordinary bank or brokerage account, whose growth is taxed every year. Annuities may offer advantages over traditional bank or brokerage accounts, including increased death benefit provisions, guaranteed earnings, bonuses, living benefits and guaranteed income for life.


Deposits into non-qualified annuities must come from your own personal savings, as opposed to a pre-tax payment from your employment paycheck. Contributions do not entitle you to an income tax deduction, regardless of how much money you deposit. No IRS restrictions exist on the amount you may put into a non-qualified annuity, but each annuity carrier may impose their own restrictions on maximum deposits.

Ordinary Withdrawals

When you reach age 59-1/2, you may begin taking distributions from your annuity without penalty. The IRS has designated 59-1/2 as the earliest age at which money from retirement accounts should be withdrawn. Since money within a non-qualified annuity is partly untaxed growth and partly post-tax deposits, taxes are not due on all of the money. The IRS follows the last-in, first-out methodology to determine how much of each withdrawal is taxable earenings and how much is a return of premium. The money most recently added to the account is considered the first to be withdrawn. The full amount of each withdrawal will be taxable until all growth has been received and your original principal remains.

Early Withdrawals

The IRS imposes penalties for withdrawing money from a non-qualified annuity prior to age 59-1/2. Since the growth portion of your annuity account is withdrawn first, the entire amount of the early distribution will be fully taxable, in addition to a 10 percent penalty. Exceptions exist for certain situations, possibly allowing you to avoid the penalty if you withdraw the money to pay for medical expenses, college tuition, because you are disabled or to purchase your first home.

Death Benefits

Non-qualified annuity contracts contain death benefit provisions allowing owners to designate a beneficiary to receive the proceeds of the account when they die. Annuity proceeds received by beneficiaries are fully taxable as ordinary income. If beneficiaries choose to take the money in a single lump sum, their tax liability for that year may be significantly increased. However, beneficiaries typically have the option of receiving annuity proceeds in a stream of payments spread out over several years, thereby reducing their tax liability to only the amounts received that year.

About the Author

Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.

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