Understanding how qualified and non-qualified annuities work will certainly help you maximise on their benefits and also account for the financial caveats they might entail. To thoroughly understand qualified and non-qualified annuities, their differences, and how each one works, we ask the following questions:
- What is an annuity?
- What is a qualified annuity?
- What is a non-qualified annuity?
- Qualified and non-qualified annuities: How are they different from each other?
What is an annuity?
A product or an investment, or both, an annuity provides a guaranteed and secured income in and during a specified period of time, usually during retirement. The income is “guaranteed” because it doesn’t rely on market performance but on the specifics included in the annuity contract.
Investing in an annuity requires one to have a considerable amount of money, invested at once, with withdrawals to be made over a specified or projected schedule in a period of time.
Annuities are generally divided into two broad categories: qualified annuities and non-qualified annuities. The key difference between these two is how they are taxed, and when. Also, as a beneficiary, you can inherit either a qualified or a non-qualified annuity.
What is a qualified annuity?
Qualified annuities are annuities eligible for tax deduction. They are subject to income tax when a distribution is initiated and made. Qualified annuities are largely considered a great investment since they feature tax-deferred earnings and attractive tax benefits and advantages. Your Superannuation (Super) money is taxed at three stages:
- As contributions, when it goes into the Super fund
- As investment earnings, or while it is in the fund
- As Super benefits, upon leaving the fund
Super contributions and taxation
Your type of contribution and your specific personal situation and circumstances determine the amount of tax you’ll pay on your super contributions.
Employer and salary-sacrificed contributions, also known as concessional contributions, are subject to taxation and get taxed at 15 per cent upon entering your Super fund.
Those who earn $37,000 or less the tax paid on their Super contributions, classified by the Australian Securities and Investments Commission (ASIC) as low-income earners, get an automatic $500 addition into their Super account, as promulgated by the Low Income Super Tax Offset (LISTO).
High-income earners, or those with a combined income and super contributions of more than $250,000, are required to pay the Division 293 tax. The Division 293 tax is an added 15 per cent tax on the amount in excess of the determined income threshold, or on the lessor of their concessional contributions.
Investment earnings and taxation
Investment earnings, or the income earned in the fund, get taxed at a maximum 15 per cent rate. On the other hand, a 10 per cent taxation will be observed on capital gains on assets held in the fund for longer than 12 months.
Note, however, that tax deductions and tax credits can help you reduce the amount you pay for the tax on your fund. For the specifics, consult with a trusted accountant and/or lawyer with a proven expertise on the subject matter.
Super withdrawals and taxation
Generally, if you are 60 years old or over, your Super income is treated as tax-free. You may pay tax on your Super pension if you are aged under 60 years.
Accessing your Super before you turn 60 years old will require you to pay tax on your withdrawals. Withdrawing up to $200,000, or the low rate threshold, is tax-free, but any other withdrawals over said amount will require a 17 per cent taxation.
Also, if you are younger than your preservation age and are withdrawing a lump sum from your Super fund, expect to be taxed at 22 per cent.
What is a non-qualified annuity?
Non-qualified annuities are not eligible for tax deductions since you, as the investor, has already paid the necessary taxes upon the inception of the said fund. However, the earned interest is taxable when it is withdrawn. Also, taxes are not due on the principal amount when you decide to withdraw it. The most popular examples of annuities under the non-qualified category are:
- Mutual funds
Investments representing ownership, claim and power over the decision-making process of a company and its assets and earnings, stocks are subdivided mainly into common and preference stocks. The main difference between common stockholders and preference stockholders is that the former is entitled voting rights not enjoyed by the latter. Stocks are also otherwise known as shares or equity.
Mutual funds are an investment vehicle established through a pool of investment amounts collected for the purpose of expending in securities like bonds, money market instruments, stocks, and other assets, operated by professional financial managers. The financial managers’ goal is to produce income and/or capital gains for you, or any other fund investor, by strategically allocating the said fund’s investments.
Your fund’s portfolio is structured to effectively correspond to your investment objectives and income goals.
Qualified and non-qualified annuities: How are they different from each other?
From the above discussion, we deduce that annuities are categorised and determined whether qualified or non-qualified based on their eligibility for taxation, among other relevant considerations. The two most important factors to consider in understanding and then determining whether an annuity is qualified or non-qualified are:
- Tax deduction eligibility
- Tax investment
Tax deduction eligibility
Generally, qualified annuities are eligible for tax deduction, while a non-qualified annuity is not eligible for tax deduction.
Qualified and non-qualified annuities are also opposites when inspected through the tax investment lens: qualified annuities are a pre-tax investment, while non-qualified ones are a post-tax investment.
Note that taxation matrices for non-qualified annuities vary in several respects, as this annuity category is purchased with post-tax money.
By now, you will have a better understanding of the difference(s) between qualified and non-qualified annuities, and how each annuity category works. Thoroughly understanding each and their financial and taxation entailments will help you make better decisions financially, whether you are purchasing annuities as an individual or engaging in group annuities (usually contained in employer-sponsored plans).
Remember that as an individual, you can purchase either a qualified annuity or a non-qualified annuity plan.
Annuity products are also contained in significant numbers of employer-sponsored plans with contributions deducted from your business’ earnings while income taxes, generally due on your deposit, get deferred to a future schedule. Corporate retirement plans also usually hold annuities that are generally categorised as a qualified annuity.
If still unclear or unsure about the specifics, never hesitate to consult with your trusted accountant and/or lawyer to help you with your questions and inform and enlighten your decision-making process on the annuities you plan to purchase and benefit from.