Qualified Annuity
An annuity funded with pre-tax dollars inside a retirement plan: the entire payment is taxable as ordinary income because no after-tax basis exists.
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What is the principal tax difference between a qualified and a nonqualified annuity?
Qualified annuity premiums are generally made with pre-tax dollars and all distributions are taxable, while nonqualified premiums are after-tax and distributions are partly tax-free via an exclusion ratio — A qualified annuity funds a tax-qualified retirement plan such as an IRA or 401(k): contributions are deductible, growth is deferred, and every dollar distributed is taxable because no basis exists. A nonqualified annuity is funded with after-tax money, so each payment is partly a return of basis and partly gain — taxed under the exclusion ratio of IRC Section 72(b). This funding-and-taxation distinction is the central difference.
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Distributions from a qualified annuity (for example, one funded through a qualified retirement plan with pre-tax dollars) are generally taxed as:
Fully taxable as ordinary income, because no after-tax basis is recovered through an exclusion ratio — With a qualified annuity, the contributions were made with pre-tax dollars and the owner did not have an after-tax investment in the contract (cost basis). Because there is no basis to recover, the exclusion ratio does not shelter any portion of the payments, and each distribution is fully taxable as ordinary income. This differs from a nonqualified annuity, where after-tax premiums create a basis that is recovered through the exclusion ratio. The distinction between qualified and nonqualified annuity taxation is a core exam concept.
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