The difference between a non-qualified annuity and a qualified annuity is its tax treatment. This is a fundamental difference that you must speak with your life insurance advisor or your accountant about to make sure you use the right source of money to buy your annuity. You will see how a non-qualified annuity has a tax advantage over the qualified annuity.
A Non-Qualified Annuity is Purchased with After Tax Dollars
Put in simple terms, the non-qualified annuity contract is bought with a cheque coming from your bank account. This is why we use the term “non-qualified” as it is not qualified as an annuity bought from a registered account (pension). It may sounds counter intuitive, but non-qualified annuities show a strong tax advantage not only compared to qualified annuities but also compared to most investment vehicles.
What is the Tax Advantage of a Non-qualified Annuity?
Since your annuity contract has been purchased with after tax dollars, your taxable rate on the annuity payment will also be reduced. When calculating the applicable tax on an annuity payment, the contract stipulates that a part of that payment is in fact a return of capital.
In other words; non-qualified annuities reimburse you, with each annuity payment, a part of your (after tax) capital that was used to purchase the contract.
Obviously return of capital is not taxable as you already paid your dues on this money. You can’t really calculate what part of the annuity payment will be taxable as an investment return and the part that will qualified under return of capital. However, your life insurance advisor will be able to demonstrate it in the non-qualified annuity contract.
Non-qualified Annuity Tax Treatment Example
Let’s presume you have $100,000 in non-registered investments. You decide to deposit the money in your bank account and buy a non-qualified annuity with the proceeds. The contract pays an 8% return. This means you receive $8,000 annually. Remember, the $8,000 is not fully taxable as you purchased a non-qualified annuity.
The insurance company calculation (mainly based on life expectancy statistics) shows a portion of return in capital of $5,000. This means the Government agrees that you receive the first $5,000 from your non-qualified annuity tax free. The remaining ($8,000 – $5,000 = $3,000) will be taxed according to your marginal tax rate. If you are taxed at 30%, this means $900 in taxes ($3,000 * 30%). Therefore, you pay a total of $900 on a $8,000 non-qualified annuity payment. That’s the equivalent of an 11.25% tax rate.
If you had purchased your annuity through your registered fund (in a tax sheltered account), your contract would have been considered as a qualified annuity. In this situation, the full $8,000 would have been taxable. Instead of paying $900 in tax as is the case with a non-qualified contract, the qualified annuity tax payable would be $2,400 ($8,000 * 30%).
Therefore, if you have investments in both non-registered and registered accounts, using your after tax dollars to buy a non-qualified annuity is definitely the best solution tax wise. As you will pay tax upon withdrawals from your registered investments, you might want to postpone tax payable on your non-registered investments.
Non-qualified Annuity Investment Strategy
There is a very interesting investment strategy to be realized with a non-qualified annuity. If you join the annuity contract with a life insurance, you can protect both your pension income and your estate. In fact, if you purchase a non-qualified annuity and die two years later, your annuity payments will be lost.
However, if you buy life insurance for the same amount, your heirs will receive the capital you used to generate your pension. It’s like enjoying the investment return of your money while you live and giving your capital to your heirs once you don’t need it.
The non-qualified annuity payments are not fully taxed and the proceeds of a life insurance is 100% tax free. This makes this strategy very interesting in terms of both retirement and estate planning. You can find more information on this strategy, also called the back-to-back annuity, here.
Where Can I Buy a Non-qualified Annuity?
Non-qualified annuities are sold by life insurance agents and directly from a life insurance company. You can contact a trusted life insurance agent by clicking here. He will walk you through all type of annuities and will help you chose what is best for you.
Non-qualified Annuity Video Explanation
While searching the web, we found this lengthy, but complete, explanation of a non-qualified annuity and its tax treatment.