A qualified annuity is an annuity which is funded with pre-tax income. Qualified annuities are usually set up through an employer as part of a pension plan which is designed to provide income for employees after retirement. With a non-qualified annuity, the funds to create the annuity come from post-tax income. The tax rules for qualified and non-qualified annuities are different, and it is important to be aware of how they work when establishing an annuity so that the best choice can be made.
With a qualified annuity, employers set up a salary reduction plan, in which workers agree to give up part of their salary to fund an annuity. Each paycheck will show the amount contributed to the annuity as a debit against the employee's salary which reduces the amount of money the employee earns. Because the money is taken out before taxes, it is not taxed at the time that it is earned, and it can count as a tax deduction to reduce an employee's taxable income.
Once the annuity matures, the employee starts to receive payments. Each payment is taxed, with people paying taxes on the principal and the earnings of the qualified annuity. With a qualified annuity, employees can also cash out the annuity early, if they are willing to pay a surrender fee and forfeit part of the money held in the annuity. Should the annuitant die, the funds will be routed to the beneficiary of the annuity, assuming that one was established when the annuity was set up.
The benefit to a qualified annuity is that it reduces tax liability while someone is working, and establishes a retirement fund so that someone will have a source of income after retirement. The disadvantage is that the total contributions are usually capped, people will need to pay taxes when funds are released, and the funds are also locked up in the annuity until it matures. For this reason, relying on a qualified annuity alone as a savings and investment vehicle is unwise. Instead, money should be invested in several locations, preferably providing some liquidity so that people will be prepared in the event of a financial emergency.
People who opt to purchase non-qualified annuities do not pay taxes on the principal, because the principal comes from post-tax income. They do pay taxes on the earnings of the annuity. Non-qualified annuities also lack contribution caps, with people putting in as much money as they want, and people can set them up independently rather than going through employers. The same lack of liquidity associated with a qualified annuity is present with a non-qualified annuity, however.