What Is a Non-Qualified Annuity and How Are They Taxed?

Non-qualified annuities are insurance contracts that can provide tax-deferred growth outside a traditional retirement account. They are funded with after-tax dollars, so contributions do not qualify for an upfront tax deduction. However, any earnings inside the contract can grow without annual taxation until money is withdrawn or annuity payments begin. At that point, the original investment generally comes back tax-free, while the earnings portion is taxed as ordinary income.

A financial advisor can help you weigh the pros and cons of whether an annuity is right for you.

What Is a Non-Qualified Annuity?

A non-qualified annuity is an annuity purchased outside a tax-advantaged retirement account or employer-sponsored retirement plan. You fund it with after-tax dollars, meaning you do not receive a tax deduction for the money used to buy the contract.

Like other annuities, a non-qualified annuity is typically issued by an insurance company. You can pay into the contract all at once or over time, and the insurer will later make payments to you according to the annuity’s terms. Those payments may last for a fixed period, such as 10 or 20 years, or for the rest of your life.

The main tax feature of a non-qualified annuity is tax-deferred growth. You do not owe taxes each year on earnings inside the contract. Instead, taxes are generally due when money is withdrawn. Because the contract was funded with after-tax dollars, the portion of each withdrawal that represents your original investment is generally returned tax-free. The earnings portion is taxed as ordinary income.

Qualified vs. Non-Qualified Annuities

The difference between qualified and non-qualified annuities comes down to how the contract is funded and taxed. A qualified annuity is purchased through a tax-advantaged retirement account or plan, such as a traditional IRA, 401(k) or 403(b). Contributions may be deductible or made with pre-tax dollars, depending on the type of account and the taxpayer’s eligibility. As a result, withdrawals from qualified annuities are generally taxed as ordinary income.

A non-qualified annuity, on the other hand, is funded with money that has already been taxed and is held outside a retirement account. You do not get an upfront tax deduction, but the earnings inside the contract can grow tax-deferred. When withdrawals begin, only the earnings portion is generally taxable, while your original after-tax investment is generally returned tax-free.

In simple terms, a qualified annuity gets its tax treatment from the retirement account or plan that holds it. A non-qualified annuity is not held inside one of those accounts, but it can still offer tax-deferred growth.

How Are Non-Qualified Annuities Taxed?

Non-qualified annuities have essentially three tax stages to understand: the investment stage, growth state and payout stage.

1. Investment Stage: No Tax Benefits

When you invest in a non-qualified annuity, you do so with money that you’ve already paid taxes on. You can’t take a tax deduction for these contributions.

2. Growth Stage: Tax-Deferred

Annuities work similarly to standard retirement accounts in that they are typically built on a series of underlying investments. Every annuity will hold different investments and manage its money differently, but they all look to grow your initial investment and use that growth to make payments once the contract annuitizes.

With a non-qualified annuity, the investment growth isn’t taxed as it accumulates. This is unusual compared to most investment accounts, which can trigger taxes when assets are sold for a gain or when dividends are paid. Even reinvested earnings in mutual funds or ETFs can generate taxable events, but a non-qualified annuity defers all of this until you begin taking payments.

Owners of non-qualified annuities do not pay these taxes until payments begin, which can leave more money in the contract to compound. If you choose, you can also have extra time to allow a non-qualified annuity to grow, as these accounts are exempt from required minimum distribution (RMD) rules during the owner’s lifetime. This allows you to begin receiving payments at any age.

3. Payout Stage: Taxes on Earnings  

You pay taxes on the money you receive from a non-qualified annuity, whether that comes in the form of the contract’s structured payouts or through a withdrawal. This money is taxed as ordinary income, not as capital gains.

However, because you paid taxes on your initial investment, you are only taxed on the profits you make off a non-qualified annuity. This means that each payment you receive has two tax components. A portion of your payment is considered your principal, and is untaxed. The rest of your payment is considered profit and you pay taxes on that.

While the IRS uses a relatively complicated process known as the General Rule for calculating this, the nontaxable portion of your payments is based on the ratio of your investment capital to the annuity’s account balance. For example, if you invested $100 and the annuity’s balance is $1,000, around 10% of your payments would typically be untaxed.

For more details, see IRS Publication 575, which explains pension and annuity taxation, and IRS Publication 939, which explains the General Rule. ^{1 2}

This tax status also applies to any heirs or spousal beneficiaries. If your payouts under the annuity transfer, for example, to a spouse, they would pay income taxes on the portion of each payment attributable to earnings. Depending on the nature of your annuity, it may also issue a lump-sum payment to your heirs after your death. This, too, would be taxed as ordinary income based on the portion that represents earnings.

What Happens to a Non-Qualified Annuity After Death

When the owner of a non-qualified annuity dies, the contract typically passes to the person or people listed as beneficiaries.

How the annuity proceeds are distributed depends on the terms of the contract and the type of beneficiary. A surviving spouse often has more flexibility than other beneficiaries. Non-spouse heirs, on the other hand, usually have to follow specific payout schedules set by the IRS or the issuing insurance company. These rules determine how long the funds can remain tax-deferred and how quickly they must be withdrawn.

If the beneficiary is a surviving spouse, they can often choose to take ownership of the annuity and continue it in their own name. This option, known as “spousal continuation,” allows the tax-deferred status of the annuity to remain in place. The spouse inherits the annuity and can keep the contract growing without immediate taxation. They will then begin taking distributions under the same or revised terms. Alternatively, the spouse can choose to take a lump-sum payout or begin receiving annuity payments right away. Each choice affects when and how taxes apply to the contract’s gains.

For non-spouse beneficiaries, the rules are different. Most must either take the full value of the annuity within five years of the original owner’s death or elect to receive payments over their own life expectancy, depending on the contract provisions. The IRS requires that income taxes be paid on the earnings portion of any amount withdrawn, while the original after-tax investment is returned tax-free. Because annuities do not receive a step-up in cost basis at death, the beneficiary’s taxable income can be higher than it would be with inherited stocks or mutual funds.

Guaranteed income from an annuity can change how you approach retirement withdrawals. Try our retirement calculator and input your annuity as pension income to see how it affects your overall outlook.

In cases where multiple beneficiaries are named, the insurer may divide the annuity into separate contracts so that each heir can choose their preferred payout method. This allows one beneficiary to take a lump-sum distribution while another continues receiving periodic payments. The timing of these choices directly influences the tax impact. Lump-sum payouts create immediate income tax obligations on the earnings, while installment payments spread out taxation over several years, potentially keeping each year’s income lower.

If the original owner had already begun receiving annuity payments before death, those payments generally continue to the designated beneficiary according to the contract’s payout structure. For example, a “life with period certain” annuity guarantees payments for a fixed number of years even if the annuitant dies early, ensuring beneficiaries receive the remaining balance. 

It’s still a good idea for beneficiaries to review the contract and consult a tax professional to understand how the annuity’s income and tax rules apply to their specific situation.

Bottom Line

Non-qualified annuities are retirement savings vehicles funded with after-tax dollars. Their earnings grow tax-deferred, and when you take withdrawals, the portion that represents growth is taxed as ordinary income while your original contributions come out tax-free. Consider working with a tax preparer or CPA if you prefer to have your tax planning managed by someone else.

Tips for Tax Planning

• So are annuities right for you? Well, it depends. As with all retirement assets, the right answer is based entirely on your needs. You may want to hire a financial advisor to help you make the right retirement decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Annuities have become a hotly debated retirement asset in recent years. Advocates argue that their certainty is very valuable, while critics suggest that you lose money relative to investing in the stock market. If you’re considering buying an annuity, make sure you consider any potential tax consequences.

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