Investors purchase qualified annuity contracts with pre-tax earnings whereas non-qualified annuity contracts are bought with after-tax earnings. Funds inside an annuity contract grow tax-deferred, regardless of whether the premiums used to fund the contract consisted of qualified or non-qualified funds. Withdrawals from qualified and non-qualified accounts are taxed very differently.
When you purchase an investment or asset, the Internal Revenue Service calls the purchase price you pay your cost basis. When you eventually sell that asset, you only have to pay taxes on the proceeds received from the sale that were in excess of your cost basis. Qualified annuities have no cost basis because premiums contain pre-tax earnings. Therefore the IRS assesses taxes on the entire balance of your annuity contract. On a non-qualified annuity, your cost basis equals your purchase premium so you only pay taxes on your withdrawals.
When you make a withdrawal from a qualified annuity, the insurance company holding your funds does not have to specify whether funds being withdrawn are comprised of principal or interest since both are taxed in the same manner. However, on a non-qualified annuity the insurance company must specify whether the withdrawals consist of principal or interest. The IRS requires annuity companies to use a last-in-first-out method for making withdrawals. This means that when you make a withdrawal, you first receive your earnings that are fully taxable. After your earnings have been depleted, you receive payments comprised of your non-taxable premiums. However, if you annuitize your non-qualified annuity, which involves converting the lump sum into a lifetime income stream, the monthly payments are comprised of both principal and earnings.
Step-up Cost Basis
When an investor dies, his assets pass to his heirs, and the IRS uses a "stepped-up" cost basis to tax those funds. This means the person inheriting the funds pays taxes using the value of the asset at the time of the original owner's death as the cost basis as opposed to the premium paid by the owner. The stepped-up cost basis rule applies to most investments, except for annuities. If you inherit a qualified or non-qualified annuity, you do not benefit from a cost basis step-up.
If you make a withdrawal from a qualified annuity prior to age 59-1/2, you must pay a 10 percent tax penalty as well as the ordinary income taxes due on the withdrawal amount. If you access a non-qualified annuity prior to age 59-1/2, you only pay the 10 percent tax penalty on earnings and not principal. Non-qualified annuities offer tax advantages because investors can start earning tax-deferred funds on money that previously was considered taxable. Qualified annuities have the same tax benefits as other retirement accounts but offer no additional benefits to people whose funds are already tax-deferred.