Understanding the difference between qualified and non-qualified annuities is important when planning for retirement. The type of money you use to fund an annuity—whether it’s pre-tax or after-tax—determines how it’s taxed later. This guide will walk you through the key differences, tax implications, and benefits of each.
Understanding Qualified and Non-Qualified Money
Before getting into annuities, let’s first define qualified and non-qualified money.
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- Non-qualified money is money you already paid taxes on before you invested it.
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- Example: Money in your checking account from wages, Social Security, or a pension.
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- Non-qualified money is money you already paid taxes on before you invested it.
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- Qualified money is money you have not yet paid taxes on—meaning you’ll owe taxes when you withdraw it.
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- Example: Funds in a 401(k), IRA, 403(b), 457, TSP, SEP-IRA, etc.
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- Qualified money is money you have not yet paid taxes on—meaning you’ll owe taxes when you withdraw it.
Type of Money | Has It Been Taxed? | Common Accounts |
Non-Qualified | Yes | Checking, savings, after-tax investments |
Qualified | No | 401(k), IRA, 403(b), 457, TSP, SEP |
If money goes into a qualified account before taxes, it will be taxed when withdrawn. If it goes in after taxes, there will only be additional taxes when you earn interest.
Tax Implications of Qualified Accounts
One major rule with qualified money is that all withdrawals are taxed as regular income. Even if you don’t need the money, the government requires you to take Required Minimum Distributions (RMDs) once you reach a certain age.
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- If born between 1951-1959, RMDs start at age 73.
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- If born in 1960 or later, RMDs start at age 75.
That means if you have money sitting in a 401(k) or IRA, at some point, you must start taking money out and paying taxes on it—whether you need it or not.
Qualified Annuities: How They Work
A qualified annuity is simply an annuity funded by qualified money—money that hasn’t been taxed yet. This happens in two ways:
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- Rolling over an existing qualified account (like an IRA or 401(k)) into an annuity.
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- Contributing money directly and taking a tax deduction on it.
Regardless of how it’s funded, all withdrawals from a qualified annuity are taxed as regular income, just like withdrawals from a 401(k) or IRA.
Benefits of Qualified Annuities
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- Potential for Roth conversions – Some annuities allow you to convert the money into a Roth IRA for future tax-free income.
Feature | Qualified Annuities |
Funded with | Pre-tax dollars (rolled over from 401(k), IRA, etc.) |
Taxation on withdrawals | Fully-taxable as income |
RMDs required? | Yes, starting at age 73 or 75 |
Eligible for Roth conversion? | Yes, in some annuities |
Roth conversions inside annuities became a new feature in late 2024, and only a handful of companies offer this option. This strategy allows you to pay taxes now and enjoy tax-free withdrawals later.
Non-Qualified Annuities: What You Need to Know
A non-qualified annuity is an annuity funded with after-tax money—meaning taxes were already paid before the money was invested.
You can fund a non-qualified annuity with:
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- Savings
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- Proceeds from selling an asset (after taxes were paid on gains)
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- Inheritance (after tax obligations are settled)
Because the money was already taxed, only the gains in a non-qualified annuity are taxable when withdrawn.
Taxation of Non-Qualified Annuities (LIFO Taxation)
Withdrawals from a non-qualified annuity follow a Last In, First Out (LIFO) rule. This means when you take money out, gains come out first and are taxed.
Example of LIFO Taxation
Scenario | Deposit | Growth | Withdrawal | Taxable Portion |
You invest $100,000 | $100,000 | $5,000 (5% growth) | $10,000 | $5,000 taxable (the growth), $5,000 tax-free return of principal |
You invest $100,000 | $100,000 | $10,000 (10% growth) | $10,000 | Entire $10,000 is taxable (all growth) |
If your annuity has significant growth, taxes can add up quickly if you take large withdrawals early.
How Non-Qualified Income Annuities Are Taxed (Exclusion Ratio)
If you use a non-qualified annuity for lifetime income, a portion of each payment is considered a return of principal (tax-free), and a portion is considered interest (taxable). This is determined using an exclusion ratio, which spreads taxes out over time.
Once all the principal has been paid back, the entire payment becomes taxable.
Key Tax Benefits of Qualified and Non-Qualified Annuities
Qualified Annuities (Pre-Tax Money)
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- No additional tax benefits—money will be fully taxed when withdrawn.
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- RMDs are required at 73 or 75.
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- Can be converted to a Roth IRA for future tax-free income.
Non-Qualified Annuities (After-Tax Money)
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- Tax-deferred growth—you don’t pay taxes on gains until you withdraw them.
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- No RMDs are required—you choose when to take the money out.
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- Can use a 1035 exchange to defer taxes even longer.
Using a 1035 Exchange for Long-Term Care Benefits
A 1035 exchange lets you move an annuity’s value into another annuity or an asset-based long-term care policy without triggering taxes.
This is useful if:
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- Your annuity has significant gains and you want to avoid taxes.
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- You want long-term care coverage with tax-free benefits.
If you never need long-term care, the money can be passed on to your beneficiaries as a death benefit.
Final Thoughts: Which Type of Annuity Is Right for You?
Choosing between a qualified and non-qualified annuity depends on:
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- Whether the money has already been taxed.
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- Your income needs and tax situation.
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- Whether you want to defer taxes or convert to a Roth IRA.
Qualified annuities are best for protecting money that has not been taxed, but you’ll owe taxes later.
Non-qualified annuities offer tax deferral on growth, flexibility in withdrawals, and potential long-term care benefits.
If you want to know which direction to go for your specific situation, use the schedule a call link and book a short meeting using my online calendar.
All The Best,
Marty
Podcast Episode 63: Qualified Versus Non-Qualified Annuities
Download Episode 63: Qualified Versus Non-Qualified Annuities on Apple Podcast