Non-qualified annuity
Funded with after-tax dollars
Qualified annuity
Funded with IRA or 401(k) dollars
| Rule | How it works | Applies to |
|---|---|---|
| LIFO rule | Last In, First Out — gains (last in) are withdrawn before basis (first in). All gains taxable as ordinary income before any tax-free basis is recovered. | Non-qualified annuities — partial withdrawals |
| Exclusion ratio | Investment ÷ Expected return = % of each payment that is tax-free return of basis. Once basis is fully recovered, all payments are 100% taxable. | Non-qualified annuities — annuitized payments only |
| 10% penalty | Early withdrawal penalty on gains (non-qualified) or full amount (qualified) if withdrawn before age 59½. Exceptions: disability, death, annuitization, substantially equal periodic payments (72(t)). | Both — if under age 59½ |
| 1035 exchange | Tax-free transfer from one annuity to another annuity, or from a life insurance policy to an annuity. Must be same owner. Preserves tax deferral without triggering current tax. | Non-qualified — between like contracts |
| RMDs | Qualified annuities inside IRAs subject to standard RMD rules. QLAC exception defers up to $200K to age 85. Non-qualified annuities have no RMDs during owner's lifetime. | Qualified — IRA-funded annuities |
| Inherited annuity — spouse | Surviving spouse can continue the contract as owner, maintaining tax deferral. No immediate tax event. | Both qualified and non-qualified |
| Inherited annuity — non-spouse | Must distribute within 5 years or take periodic payments over their life expectancy beginning within 1 year of owner's death. All gains taxed as ordinary income to beneficiary. | Non-qualified inherited contracts |
| Roth annuity | Annuity held inside a Roth IRA. All qualified withdrawals are completely tax-free. No RMDs. Most powerful annuity tax structure available. Roth 5-year rule applies. | Roth IRA — funded with after-tax Roth contributions |
When and how to use a 1035 exchange
IRC Section 1035 allows a tax-free exchange from one annuity contract to another — as long as the owner remains the same. This is valuable when you want to upgrade to a product with better rates, lower fees, a higher bonus, or additional features without triggering a current tax event on accumulated gains.
What qualifies: Annuity to annuity, life insurance to annuity, life insurance to life insurance. Does not work in reverse — you cannot exchange an annuity into a life insurance policy.
What does not qualify: Partial exchanges require careful structuring. Changing ownership or beneficiary at the time of exchange can disqualify 1035 treatment. Always use a direct carrier-to-carrier transfer — never take a distribution and then deposit into a new contract.
The most powerful structure — Roth IRA + annuity
Placing any annuity inside a Roth IRA combines the Roth's tax-free withdrawal benefit with the annuity's principal protection, guaranteed income, and tax deferral. All qualified withdrawals are 100% tax-free. There are no RMDs during the owner's lifetime. And the 0% floor of an FIA inside a Roth means the account cannot go backwards. This is the strongest single tax structure available for retirement income planning.
What happens to an annuity at the owner's death
Spouse beneficiary: May continue the contract as owner with full tax deferral preserved — no immediate tax. This is the most tax-efficient beneficiary option.
Non-spouse beneficiary (non-qualified): Must distribute within 5 years or elect periodic payments beginning within 1 year. All gains in excess of the original cost basis are taxable as ordinary income to the beneficiary — there is no step-up in cost basis for inherited non-qualified annuities.
Qualified annuity beneficiary: Subject to the inherited IRA 10-year rule under the SECURE Act — full distribution required within 10 years. All distributions are 100% ordinary income. This is why converting IRA-funded annuities to Roth before death is so strategically valuable.