| A nonqualified annuity is purchased outside of an employer-provided retirement plan. After-tax dollars are used to fund a nonqualified annuity, so contributions are not deductible from gross income for income tax purposes. Taxes on interest or earnings in a nonqualified annuity are deferred until withdrawal. In a lump-sum distribution of a nonqualified annuity, the monies may be transferred into an IRA or similar vehicle to defer taxes additionally. Only a portion of a monthly annuity payment is taxed because each payment is partially principal that has been taxed and partially interest earned. The portion of the monthly payment that is excluded from taxes is determined by an exclusion ratio. The exclusion ratio is the total amount of premiums paid divided by the total expected payment amounts. If the expected return is based on a life expectancy or joint life expectancy, the Internal Revenue Service has tables and multipliers that are used to determine the total expected return. If the expected return is not based on a life expectancy, the total expected return is the sum of all amounts to be received.
With the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax rate on capital gains dropped from 20 to 15 percent. Dividends are now taxed at 15 percent. Variable annuities, a good example of a nonqualified annuity, may be less attractive for some investors because the variable annuity may have to be held for longer periods to reap the tax-deferred benefits.
An individual or an entity may purchase a nonqualified annuity. Nonqualified annuities are typically purchased by or for employees who have contributed to the full limits under a qualified plan. Unlike a qualified annuity, the source of the funds is not confined to earned income. Additionally, federal law does not impose a limit on the amount of annual contributions to a nonqualified annuity. However, the issuer may impose a total contributions limit. Federal law also does not impose a minimum required distribution on a nonqualified annuity, but some annuity issuers or providers (and certain states) may require distribution of income by an age certain such as 90 years of age.
Internal Revenue Code Section 72(q) lists the circumstances under which an early withdrawal from a nonqualified immunity (prior to the age of 59 and one-half years) is not subject to the 10 percent early withdrawal penalty. However, no early withdrawal penalty is imposed in the event of death or disability or when a distribution is taken in substantially equal payments over a life expectancy. The recipient must continue to receive the payments for five years or until reaching the age of 59 and one-half years, whichever is longer. Otherwise, the 10 percent early withdrawal tax plus interest will be imposed retroactively on all payments made.
Annuity issuers generally apply gender-based actuarial tables and rates to certain qualified and most nonqualified annuities. However, some states require issuers to use a rate that is not gender-based.
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