In our industry, many annuities are purchased using rollovers from traditional, taxable, qualified accounts like 401(k)s or IRAs. But there are a significant number of annuities that are purchased with already-taxed, nonqualified money from other sources. And this might be a good move for some HNW people, depending on their goals.
Here are some things to know about payout rules that apply to nonqualified annuities.
First of all, remember that when an annuity is purchased with qualified money, all amounts annuitized or withdrawn are taxable at ordinary income tax rates. But when annuities are purchased with nonqualified money, only the gains are taxed.
For tax purposes, the IRS uses the LIFO (last in, first out) rule for annuity withdrawals. This means that gains or earnings are taxed first, until all earnings are gone or depleted. Then the withdrawal of the original principal is tax-free. Additionally for younger clients, remember that all annuities are subject to a 10% penalty on any taxable withdrawal before age 59-1/2; which with nonqualified annuities, means the gains portion first.
A Recent Example
ThinkAdvisor published commentary on May 6, 2026, by an advisor named John Stevenson titled, “Small Annuity Decisions, Big Tax Consequences.” John shared an example of how he helped his 65-year-old client, a man who had several million dollars invested in the market. The client wanted to leave most of that for long-term growth, but he also wanted an income stream he could count on regardless of market gains or losses.
John did the research, and found that a fixed indexed annuity with an income rider would pay around $200 extra per month more than an immediate annuity or SPIA. So, his client used $750,000 of nonqualified money and started income right away, which was around $5,000 per month for life, or $60,000 per year.
Where things got interesting centered around taxes. Because the client was already in the 32% tax bracket, and already had high income that tax year from other sources, he was concerned. He had planned on taking a frugal $30,000 from savings to live on until the next tax year.
But nonqualified annuity income isn’t taxed right away. There are no earnings yet in the first year because interest isn’t credited until the end of the contract year. That meant the income he received in Year 1 wasn’t taxable, it was principal only.
In this client’s case, since he annuitized in April, that was $40,000, about $10,000 more than he originally planned to live on, without increasing his tax bill. And at the same time, he locked in lifetime income.
Consider Taxes In All You Do
We recommend you team up with a CPA or other tax professional when recommending any tax strategy. If you have a HNW client in a high-income year who wants a dependable floor of income for the long-term, without tax consequences in the first year, you may consider using a nonqualified annuity. The last thing a client with an elevated tax bracket wants is more taxable income. Using nonqualified annuity income in that first year may give your client cash flow without adding to their tax problem.
If you’re interested in how annuities purchased with qualified or nonqualified money work, please give us a call today at 800.440.1088. We’re happy to run case designs based on your client parameters and goals.
Sources:
https://www.thinkadvisor.com/2026/05/06/small-annuity-decisions-big-tax-consequences
https://www.northwesternmutual.com/life-and-money/how-is-an-annuity-taxed/
https://www.bankrate.com/retirement/nonqualified-annuity/
Information About Inherited Annuities and the SECURE Act
The Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in late 2019 brought many changes to inherited taxable qualified account rules, including annuities. But the SECURE Act and its clarifying regulations did not change some payout rules for beneficiaries of nonqualified annuities (both deferred and immediate), which were and are already very different.
In general, depending on the insurance carrier, a non-spousal heir may be able to keep an inherited nonqualified annuity, but only by choosing a specific payout option, such as annuitizing the contract over their own life expectancy. Some carriers, like Nationwide, require this be done within one year of the owner’s death. And without this “stretch” option, non-spousal heirs generally must empty the account within five or 10 years of the owner’s death, depending on the insurance carrier and the specific contract terms.
Feel free to download this whitepaper from Nationwide, “Beneficiary payout rules for IRAs and nonqualified annuities after the SECURE Act.” And as always, we are here to help you with specific questions!
A 15-year industry veteran, Marc supports several of the nation’s leading wealth advisors and RIAs. He is a top 10 consultant nationwide and has been a top marketer since 2006, providing advisors with verified, time-tested strategies that are derived from his longevity in the business.
