Annuities are a way of saving for retirement with the possibility of a tax sheltered investment. The difference between a qualified annuity and a nonqualified annuity is in the way the money is taxed by the government. When you put money into an annuity, you can choose a qualified annuity which is funded with pre-tax dollars or you can choose a nonqualified annuity which is funded with after-tax dollars.
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You are limited as to what type of annuity you can buy. Qualified annuities are funded with pre-tax dollars only through an employer. You cannot purchase a qualified annuity privately. Nonqualified annuities can be purchased privately and are funded with after-tax dollars. Each type of annuity has its own set of benefits.
Choosing the type of annuity that is best for you depends on a number of factors, including opportunity. If you want a qualified annuity but do not work for an employer who offers it as a benefit, then you may not be able to get a qualified annuity. As an alternative option, you will have to consider buying a nonqualified annuity.
The Fundamentals of a Qualified Annuity
Qualified annuities are offered by some employers as part of their benefits package and retirement savings plans. Annuities purchased through employers are treated the same was as other employee investment contributions. Just like IRA contributions and 401k contributions, annuities are tax deferrable.
When you make a contribution to an annuity through your employer, you are using pre-tax dollars. This means that you are funding your account through payroll deductions before payroll taxes are calculated. Therefore, you are not paying tax on the portion of your income that you are contributing to your annuity. Your annuity qualifies for tax-deferral.
The benefit to a qualified annuity is that your paycheck will be a little larger than if you had to pay income tax on your entire gross earnings. However, the qualified annuity is only tax deferred, it is not tax free. This means that you eventually have to pay income tax on your contributions. You will be taxed on those contributions at the time you withdraw your funds.
You will also be taxed on your investment earnings. When you buy an annuity, your money is expected to grow with investment earnings. Those earnings are income taxable at the time you begin to withdraw from your annuity account.
Self employed individuals and small business owners can establish annuity opportunities for their employees. They are not allowed to discriminate with eligibility, so everyone must be allowed to participate and contribute the same. It is a good idea to seek guidance from a qualified tax or financial advisor on how to properly and legally establish an employee funded qualified annuity.
The Fundamentals of a Nonqualified Annuity
A nonqualified annuity is an annuity that does not qualify for tax-deferred contributions. This means that if you buy a private annuity, regardless of the type of annuity it is, it is nonqualified. You will fund your annuity with after-tax dollars, usually by paying your insurance company directly for the annuity.
Since you are using after-tax dollars to buy your annuity, you will not have to pay income tax on that part of the money when you withdraw it. After all, you already paid income tax on that money when you initially earned it and received it through payroll. However, you will still have to pay income tax on the money you earned from your investments.
Purchasing Qualified or Nonqualified Annuities
Annuities may not be the ideal investment choice for everyone, but if your employer offers an annuity option, you should consider it. With a qualified annuity you get the benefit of a tax-deferred investment that will provide you with some earnings and a monthly income stream when you retire.
Whether your employer offers an annuity option or not, you may want to consider buying a nonqualified annuity. By purchasing the annuity with after-tax dollars you won’t have to worry about income taxation for your contributions when you withdraw the funds. Your monthly income will be tax free except the portion that is from capital gains.
The only real difference between a qualified annuity and a nonqualified annuity is the time frame in which you are required to pay your income taxes on that money. Since annuity investments are only tax deferred, you will have to pay taxes at some point. You will either pay taxes on your income when you buy your annuity or when you withdraw your annuity.
All of the other fees and penalties associated with annuities apply to both qualified annuities and nonqualified annuities. The growth you can expect from your annuity will depend on your risk taking comfort zone and the type of annuity you ultimately buy.
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