Annuities are classified as either “qualified” or “nonqualified”, and there is a big difference between the two when it comes to future planning. It is prudent to understand the classification of whether money is qualified or non-qualified when strategizing for retirement and how accounts will be taxed, while living, and at death.
A quick breakdown between these accounts:
Qualified Money
Qualified Money is generally money that has not been taxed (unless it’s a Roth 401k). Qualified money is usually contributed to a pre-tax tax 401k, 403b, 457. When people retire, they typically roll this money over and it becomes a Traditional Individual Retirement Account (IRA). People don’t pay taxes on amounts in their traditional IRA until they take a distribution (withdrawal) from their IRA. However, withdrawals, including contributions and earnings, are subject to state and federal income taxes.
There’s also a 10% federal penalty tax on withdrawals before age 59½. Currently, at age 72, a required minimum distribution (RMD) must be withdrawn from a retirement account each year. RMDs are required to satisfy federal tax rules and ensure the government collects income tax on tax-deferred accounts. Money distributed from pre-tax qualified accounts is currently taxed as ordinary income. Qualified money is commonly referred to as pre-tax money.
Non-Qualified Money
Non-Qualified Money is money that has already been taxed. Non-qualified money can be money deposited into people’s checking account from their paycheck at work. Generally, employers withhold taxes which are sent to the Internal Revenue Service (IRS) and the rest is deposited into your checking account. Inheritances are also a source of non-qualified money.
One of the best advantages of non-qualified money is a “step-up in basis”, which is a friendly tax provision for inherited assets at the time of the previous owner’s death. Examples of non-qualified assets that take advantage of the “step up in basis” are real estate, bank accounts, stocks, artwork, collectibles, and businesses.
Are you wondering what this has to do with an “Annuity Ticking Tax Time BOMB!?” Unfortunately, a lot of people purchase annuities with non-qualified money without understanding future tax ramifications. When the
owners of non-qualified annuities take withdrawals from the annuity the earnings are taxed as ordinary income.
When the annuity owner passes away, the earnings are also taxed as ordinary income, and there is no “step up in basis”. This means the interest earned during the non-qualified deferred annuity will be taxable as ordinary income while the policy owner is alive or at death, hence the “tax time bomb.”
If you are reading this and wondering if you purchased an annuity with non-qualified money and need help, we have good news for you. In 2010, the Pension Protection Act’s (PPA) long term care benefits took effect. Before the PPA, people had to pay taxes on the tax-deferred growth inside of non-qualified annuities when withdrawing money for their long-term care (LTC) expenses. Unfortunately, this condition still applies today if anyone owns a traditional annuity that’s not designed to work under the PPA. One solution could be to 1035 exchange your existing non-qualified annuity, especially if you do not already have a plan in place for long-term care.
These newer products also have multipliers for LTC benefits, which means if someone contributed $100,000 after taxed non-qualified money and the current annuity value is $200,000, annuity owners can 1035 exchange their annuity value of $200,000 and potentially have a pool of $600,000 they can use tax free for eligible long term care expenses. This could alleviate future ordinary income taxation, ultimately creating a more efficient frontier for your portfolio should you or spouse need custodial care while you are alive.
We understand a lot of people need help with their existing annuities and welcome the opportunity of bringing clarification and potential solutions for both qualified and non-qualified annuities. Pacific Insurance Group is based out of Bellevue Washington, but we are licensed in many states across the United States and look forward to speaking with you in person, over the phone, or through the computer. Schedule a free appointment on our website or give us a call.
