A qualified annuity is an annuity that is purchased inside tax of a qualified plan. The IRS has issued tax guidelines for a number of ‘qualified’ accounts, which have the following taxation benefits.
- Tax deduction for contributions to the account
- Earnings from savings and investments sources accumulate and compound tax free
- Distributions are taxed as ordinary income at the tax rates in effect in the year of distribution
Qualified accounts include:
- Profit sharing plans
- Individual IRA’s
- and others
Many annuities that are purchased inside a qualified account are structurally identical to their non-qualified tax deferred annuity cousins.
When an annuity is inside a qualified account the tax rules for the qualified account supersede those of the annuity and the annuity is taxed in the same manner as any other asset in a qualified account.
The taxation of qualified accounts is straightforward and relatively simple:
- Deposits: Money deposited to a qualified account is deductible in the year of the contribution. If the deposit is made by an employer for the benefit of the employee, then the deposit is deductible to the employer and is not taxed to the employee.
- Earnings: Earnings from savings accounts and investments, whether interest, dividends, capital gains or other revenue is not taxed. This makes qualified accounts an excellent vehicle to compound earnings over a long period of time.
- Distributions: Amount distributed from the qualified account to the individual owner or beneficiary are taxed as ordinary income in the year of receipt.
Required Minimum Distributions: Qualified accounts are intended to fund retirement and have a feature built in that forces retirement distributions after a certain age. Beginning at age 70 ½ the tax code requires the account owner to make distributions based on their life expectancy. If the distribution is not made, a penalty tax is levied against the account which is excessive.
This is called the RMD (Required Minimum Distribution) and the amount distributed is based on life expectancy tables published by the IRS. The tables make no allowance for the health of the account owner. Therefore, a qualified account owner lying in a hospital bed with a week to live has the same assumed life expectancy as an individual running marathons. As would be expected, the life expectancy decreases with age and therefore, the RMD factor continuously increases.
Death: At the death of the qualified account holder the entire balance of the account is taxable to the beneficiary as ordinary income. Therefore, if an account holder dies with a qualified account balance of $250,000, the transfer would generate a tax of $75,000 assuming a 30% tax bracket
Tax Free Transfer of Funds: Subject to the internal written rules of your qualified account sponsor, you are free to transfer funds from one qualified account to another, without an immediate tax liability. If you have $25,000 in one IRA earning low interest rates, you are free to roll your $25,000 to another IRA account that is either safer or provides a higher potential yield.
Stretch IRA: An IRA account has a special provision that allows you to avoid the above death tax and structure the account to pay a continuous stream of income to your surviving spouse and then to your children. This is called the ‘stretch’ provision. Employer sponsored qualified accounts from a 401k or profit sharing plan do not have this option. Therefore, retired individuals with these types of accounts, should strongly consider the advantages of moving these funds tax free to an individual IRA.
** The tax information provided above is intended as solely as a general summary and is not intended, and should not be used, as tax advice in any specific situation or for any specific individual or entity. Interest readers should seek specific tax council from a trained and properly licensed professional.
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