When saving money for your retirement, you have several choices as to what financial products to use. One option is an annuity. Annuities are insurance policies that guarantee you an income during your retirement. Payments may be immediate or deferred to a time you specify. While you do pay tax on some part of your non-qualified annuity, they do receive certain tax advantages over other investments.
Non-qualified annuities are annuities that are not held inside of a retirement plan that is qualified for certain tax benefits by the Internal Revenue Service. Examples of qualified retirement plans would be an employer sponsored 401k plan or an Individual Retirement Account (IRA). However, even though these annuities are considered "non-qualified," they are still retirement plans for tax purposes and, as such, they do receive certain tax benefits.
Contributions to a non-qualified annuity must be made with after-tax dollars, unlike a contribution to a 401k or Traditional IRA. However, investment income within the plan is still tax-deferred, meaning you will not pay taxes on it until you receive a distribution.
The benefit of a non-qualified annuity is that these contracts do not have any mandatory withdrawal rules imposed on them. Traditional IRAs force withdrawals by age 70 1/2. This forces the payment of taxes at some point during your lifetime. With a non-qualified annuity, you control when or if you take a distribution and, consequently, when you will pay the taxes on investment income.
The disadvantage to a non-qualified annuity is that the contributions are not pretax, and the investment gains are taxed when you withdraw money from the contract. For deferred annuities, your withdrawals are treated as though you are withdrawing interest first, before principal. This means that you pay tax on 100 percent of your withdrawal until you start withdrawing your principal amount. Annuities are also subject to similar penalties as qualified plans for any withdrawals made prior to age 59 1/2. So, if you make early withdrawals from your annuity, you'll pay a 10 percent penalty on top of any income tax due.
Instead of investing in a non-qualified annuity, you may consider setting up a Roth IRA annuity. The Roth annuity eliminates the tax on withdrawals during retirement. Alternatively, you could place your annuity inside of an IRA. This would allow you to make pretax contributions to your annuity policy.