A qualified annuity is an annuity product purchased with funds from a tax-advantaged retirement plan. In simple terms, you use pre-tax retirement funds (such as those from a 401(k), 403(b), or traditional IRA) to purchase a qualified annuity. During the growth phase of the annuity, you do not pay income tax on interest earnings or capital gains; however, once you start withdrawals or receive income distributions, the entire amount received is subject to taxation (with the exception of ROTH accounts).

Qualified annuities are typically funded by existing tax-advantaged retirement accounts, such as 401(k) and 403(b) accounts, but most commonly by IRAs (Individual Retirement Accounts).

1. 401(k) Accounts: Created by for-profit companies, these accounts allow employees to defer part of their pre-tax salary, with many companies offering employer matches. Currently, annuity options within 401(k) plans are rare, but with the passage of the SECURE Act in 2019, more companies may include annuity options in their 401(k) plans. If your employer’s 401(k) plan does not offer an annuity option, you can roll over your 401(k) into your own IRA upon leaving the company and use those funds to purchase a qualified annuity.
2. 403(b) Accounts: Similar to 401(k) accounts but tailored for different groups, 403(b) accounts are provided by tax-exempt organizations for employees such as teachers and public service workers.
3. Individual Retirement Accounts (IRA): Another tool for acquiring qualified annuities. IRAs come in various types, including traditional IRAs and ROTH IRAs. You can use existing IRA funds to purchase a qualified annuity or make new contributions for this purpose. New contributions are subject to annual limits set by the IRS, which for 2024 are $7,000, or $8,000 for those over 50. However, transfers and rollovers from established IRA accounts do not count towards this annual limit.

In a qualified annuity, your funds grow tax-deferred, meaning you do not pay taxes on interest earnings or capital gains during the accumulation phase. However, when you begin receiving annuity payments, the amounts received are taxed as ordinary income. It’s important to note that these tax rules do not apply to ROTH IRAs, as contributions to ROTH IRAs are made with after-tax dollars and qualified withdrawals are tax-free.

With the implementation of the SECURE Act in 2019, more companies are likely to add annuity options to their retirement plans, offering employees a more diversified range of retirement income choices. This trend will enable more individuals to take advantage of the benefits of qualified annuities, ensuring a stable income source in retirement.