If you own a non-qualified annuity or are the beneficiary of an annuity, you must familiarize yourself with the taxation of these accounts and what potential liability exists for withdrawals and death benefit payouts. Annuities are retirement investment vehicles, and money held within these accounts is subject to tax laws established by the Internal Revenue Service.
Non-qualified annuity contributions are made with after-tax money. Unlike qualified deposits into employer-sponsored retirement plans or IRAs, non-qualified annuity contributions do not result in income tax deductions. No IRS limit exists on how much money you may deposit into this type of annuity, but some annuity carriers may impose their own maximum limits.
Money within a non-qualified annuity accumulates on a tax-deferred basis. Regardless of how much the account value increases in a given year, no taxes are due. Instead, the growth continues to accumulate without tax until it is withdrawn.
IRS regulations require money within retirement accounts, including annuities, to remain there until the account owner reaches age 59-1/2. When you begin taking withdrawals after reaching the designated age, the untaxed portion of the distributions is added to your taxable earnings for the year. You receive the portion of withdrawals deemed a return of your deposits without tax liability.
Even though IRS regulations require you to leave money in your annuity until you reach age 59-1/2, you can make withdrawals prior to reaching the designated age. The penalty for early withdrawals is an additional tax of 10 percent of the distribution amount, which is added to the ordinary tax liability stemming from the growth portion of the distributions.
Non-qualified annuity contracts contain beneficiary provisions allowing you to designate someone to receive the money in your account if you pass away. Death benefits distributed to beneficiaries from non-qualified annuities are taxed as ordinary income. This holds true even if the beneficiary chooses to receive the benefit as a stream of payments rather than a lump sum. The portion of the annuity value received by the beneficiary is added to his taxable income for that year. The only exception to this rule is when the beneficiary is the annuity owner's spouse, in which case the IRS allows the account to be continued in the spouse's name without tax implications.