The Federal Income Tax on Nonqualified Annuities

Annuities are retirement investment vehicles managed and maintained by life insurance companies. Qualified and nonqualified annuities are identical except for the tax treatment of the owner's contributions and withdrawals. Because nonqualified annuities contain a mix of pre- and post-tax money, determining the income tax liability created by distributions can be confusing.

Qualified vs. Nonqualified

Annuities are classified as qualified or nonqualified based on the deductibility of your contributions. Deposits to qualified annuities result in a dollar-for-dollar income tax deduction, up to the maximum contribution limits established by the Internal Revenue Service. As of 2012, qualified retirement account deposits cannot exceed the lesser of 100 percent of your earned income or $5,000. Deposits into nonqualified annuities do not result in an income tax deduction, and no maximum contribution limits exist.

Taxation During Accumulation

Money deposited in a nonqualified annuity accumulates on a tax-deferred basis. Any growth in the account remains untaxed until the year it is withdrawn. Regardless of how large or small an annuity account becomes, taxes are not due on the money if it remains in the account.

Retirement Distributions

Depending on the specific type of nonqualified annuity you own and the account's performance, distributions may consist of taxed and untaxed money. For income tax purposes, insurance companies use the "last in, first out" method for determining the taxable part of each withdrawal. This means interest credited to your account is withdrawn before your original deposits. A distribution from a nonqualified annuity is fully taxable until the total of your aggregate withdrawals equals the earnings. Afterward, your annuity distributions are tax-free because the insurance company is simply returning your post-tax deposits.

Early Withdrawal Penalty

Because annuities are retirement vehicles, the IRS requires that money in these accounts remain until you are at least 59 1/2 years old. If you withdraw funds before then, you will most likely have to pay a 10 percent early withdrawal penalty. This penalty is assessed on the taxable part of the amount withdrawn.

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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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