Non-Qualified Annuity
An annuity funded with after-tax dollars; only the earnings are taxable at withdrawal.
A non-qualified annuity is an annuity funded with after-tax dollars rather than money from a tax-qualified retirement account. Because the premium was already taxed, only the earnings portion of any withdrawal is taxable, and withdrawals follow last-in-first-out ordering so that gain comes out before basis. Unlike a qualified annuity, a non-qualified contract carries no required minimum distribution during the owner's lifetime.
- —Only earnings are taxed on withdrawal, since the premium itself was already after-tax money.
- —Withdrawals follow last-in-first-out ordering: gain is treated as coming out first and is taxed as ordinary income.
- —No required minimum distributions apply during the owner's lifetime, unlike a qualified contract.
- —Once annuitized, an exclusion ratio applies, treating each payment as part return of basis and part taxable earnings across the payment period.
Withdrawals follow last-in-first-out ordering, meaning gain is treated as withdrawn before basis. No required minimum distributions apply during the owner lifetime.
Once annuitized, the exclusion ratio applies, treating each payment as part return of basis and part taxable earnings across the payment period.
How withdrawal taxation works
Non-qualified annuities are taxed on a last-in-first-out basis before annuitization, meaning any gain the contract has accumulated is deemed to come out first and is taxed as ordinary income. Only once all gain has been withdrawn does a withdrawal begin to represent a tax-free return of basis. A withdrawal before age 59 and a half can also trigger an additional 10 percent federal penalty on the taxable portion, subject to standard exceptions.
| Event | Tax treatment |
|---|---|
| Withdrawal before annuitization | Gain taxed first (LIFO), as ordinary income; basis withdrawn tax-free once gain is exhausted |
| Withdrawal before age 59 and a half | Taxable portion may also incur a 10 percent federal penalty, subject to exceptions |
| Payment after annuitization | Exclusion ratio applies - part return of basis, part taxable earnings, in each payment |
| Death benefit to a beneficiary | Gain above basis is taxable to the beneficiary; basis is not |
Why no lifetime RMD changes the planning picture
A non-qualified annuity has no required minimum distribution during the owner's lifetime, since the government has no unrecovered tax deferral to force out of after-tax money. That gives an owner more control over the timing of withdrawals than a qualified contract allows, which can matter for managing taxable income in a given year or coordinating with other retirement accounts that do carry RMDs.
The exclusion ratio after annuitization
If a non-qualified deferred annuity is annuitized into a stream of periodic payments, the LIFO ordering rule no longer applies. Instead, an exclusion ratio is calculated at the start of the payment period, based on the ratio of basis to expected total payments, and that same ratio applies to every payment for its duration, splitting each one between a tax-free return of basis and taxable earnings.
- —The exclusion ratio is fixed at the time payments begin and generally does not change afterward
- —Once basis has been fully recovered under the ratio, remaining payments become fully taxable
- —A life-contingent payout that outlives the expected payment period can result in fully taxable payments before the owner's actual life expectancy
Frequently asked questions
- How is a non-qualified annuity taxed differently from a qualified one?
- A non-qualified annuity is funded with after-tax dollars, so only earnings are taxed on withdrawal, using last-in-first-out ordering. A qualified annuity is generally funded with pre-tax dollars, so distributions are usually fully taxable as ordinary income.
- Do non-qualified annuities have required minimum distributions?
- No, not during the owner's lifetime. Required minimum distribution rules apply to qualified accounts because they defer tax on pre-tax contributions. A non-qualified annuity was funded with after-tax money, so there is no such requirement during the owner's life.
- What is the exclusion ratio in a non-qualified annuity?
- It is the fraction of each annuitized payment treated as a tax-free return of basis versus taxable earnings, calculated once at the start of the payment period and applied consistently to each payment for its duration.
- Is there a penalty for early withdrawal from a non-qualified annuity?
- The taxable portion of a withdrawal taken before age 59 and a half can be subject to an additional 10 percent federal penalty, on top of ordinary income tax, subject to standard exceptions in the tax code.