Annuities are retirement investment vehicles created and managed by life insurance companies. Non-qualified annuities are simply those purchased outside of a formal retirement plan like an IRA or 401k. However, even though non-qualified annuities are not subject to the same contribution limits and maximums as those within formal retirement plans, they are still subject to same taxes, restrictions and penalties regarding withdrawals.
Non-qualified annuities are those funded with money that has already been taxed. Deposits into non-qualified annuities come from existing personal savings or current earnings. You are not obligated to contribute, and you cannot be penalized for failing to make deposits. Contributions do not result in an income tax deduction and no restrictions exist on how much money you may deposit into a non-qualified annuity.
Money within a non-qualified annuity accumulates without tax liability until you withdraw it. Since contributions are not eligible for income tax deductions, the account is a mixture of taxed and untaxed funds. Any growth within the account continues to accumulate without taxes due until you actually take possession of the money.
Withdrawals from non-qualified annuities may increase your taxable earnings for the year. The IRS uses the last-in-first-out (LIFO) methodology to determine how much of each distribution is taxable, which states that the money most recently added to the account is also the first to be withdrawn. This means that every distribution will be entirely comprised of untaxed growth, until the aggregate distributions completely encompass all growth within the account. Only then will subsequent withdrawals include the original previously-taxed deposits.
IRS regulations state that withdrawals from retirement investment accounts will result in penalties if those withdrawals occur before the account owner reaches age 59 1/2. If you take a distribution from your non-qualified annuity before you attain the appropriate age, and that distribution contains previously-untaxed growth, you will incur a penalty of 10 percent of the untaxed portion of the withdrawal. This penalty only applies to the growth in your account; if your annuity contains no growth, you will receive the money without penalties or taxes due.