Qualified and non-qualified annuities have different tax and financial aid treatment. Qualified annuities are treated like retirement plans on the Free Application for Federal Student Aid (FAFSA), while non-qualified annuities are reported as investments on the FAFSA. A similar treatment applies on the CSS Profile form.
What is an Annuity?
An annuity provides a series of regular periodic payments, often on a monthly or annual basis.
Annuities may be used in connection with retirement, to provide the investor with guaranteed income.
The duration of an annuity may be for a specified number of years or for the rest of the investor’s life. If the annuity is intended to provide lifetime income, the payouts will be based on the investor’s life expectancy.
Annuities are not really investments, but rather insurance contracts that are sold by insurance companies, banks and brokerages.
An annuity’s guarantee is only as good as the company making the guarantee. If the company were to fail, the annuity’s payout will end. So, it is best to diversify the investment by buying annuities from several highly-rated insurance companies. Some states have guarantee associations that cover the annuity’s payout up to a specified coverage limit, typically $250,000.
Advantages and Disadvantages of Annuities
There are several pros and cons of annuities.
Annuities provide tax-deferred growth and a predictable income stream in retirement. Annuities can protect against financial mismanagement and bad investments. Annuities can pass outside of probate.
A life annuity ensures that the investor doesn’t outlive their assets, but may offer a lower payout.
But, annuities lack liquidity and are complicated financial products. Annuities have high commissions and fees, and offer a low return on investment.
Cost of an Annuity
Annuities charge high annual fees and commissions.
The commissions on an annuity can be as high as 10% and are often around 7%.
There may be early withdrawal penalties, called surrender charges, if the investor withdraws money during the first several years of the annuity contract.
Annuities may also have charges for insurance risk, underlying fund expenses and administrative fees.
The growth of an annuity may be less than stock market performance because the investment returns may be capped.
Tax Impact of Annuities
There are two main types of annuities, qualified and non-qualified annuities. Contributions to a qualified annuity are with before-tax dollars while contributions to a non-qualified annuity are with after-tax dollars.
There are several similarities in the tax treatment of qualified and non-qualified annuities:
- Earnings in both qualified and non-qualified annuities accumulate on a tax-deferred basis.
- Distributions from qualified and non-qualified annuities prior to age 59-1/2 may be subject to a 10% tax penalty on the earnings portion of the distribution.
- Earnings in both qualified and non-qualified annuities are taxed as ordinary income, not capital gains. Ordinary income tax rates are generally higher than capital gains tax rates. Thus, investments in the stock market may have lower taxes than an annuity.
There are also several differences in the tax treatment of annuities, as shown in this table.
Financial Aid Impact of Annuities
Qualified retirement plans, such as qualified annuities, are not reported as assets on the FAFSA. Non-qualified annuities, on the other hand, are reported as investments on the FAFSA.
The Higher Education Act of 1965 [20 USC 1087vv(f)(1)] defines assets on the FAFSA as including tax shelters.
The FAFSA instructions specify that “Investments do not include … retirement plans (401[k] plans, pension funds, annuities, non-education IRAs, Keogh plans, etc.).” Annuities are not reported as investments on the FAFSA only in the context of annuities as a form of retirement plan, namely qualified annuities.
There are several characteristics of qualified retirement plans that distinguish them from investments:
- There is a federal cap on annual contributions
- Earnings accumulate on a tax-deferred basis
- There is a tax penalty on early distributions
- Investors are required to take distributions at a particular age
Non-qualified annuities are more similar to a non-retirement asset, like a 529 college savings plan, than a retirement asset.
The annual contribution limit is important. Non-qualified annuities do not have annual contribution limits. Without an annual contribution limit, investors can move arbitrarily large amounts of assets into a non-qualified annuity. Requiring families to report non-qualified annuities as investments on the FAFSA prevents them from using a non-qualified annuity to temporarily shelter the money from need analysis on the FAFSA.
Otherwise, if a non-qualified annuity were considered to be a non-reportable retirement asset, nothing would stop a family from making a lump sum contribution to a non-qualified annuity before filing the FAFSA, thereby sheltering the money from need analysis, and then taking an early distribution after the child graduates from college. The tax penalty on early distributions applies only to the earnings portion of the distribution, which would be small over the short term of a child’s college career.
Use this Financial Aid Calculator to estimate your expected family contribution (EFC) and financial need based on student and parent income and assets, family size, number of children in college, age of the older parent and the student’s dependency status.
The CSS Profile has a similar treatment of qualified and non-qualified annuities. The instructions from the CSS Profile explicitly state that “Investments include … non-qualified (non-retirement) annuities …”
The CSS Profile will also consider qualified annuities and other retirement assets if the amount of retirement assets is unusually high compared with age and income.
Distributions from all annuities, including qualified annuities and non-qualified annuities, are reported as income on financial aid application forms. The payouts from an annuity will either be included in adjusted gross income (AGI) or reported as untaxed income. Both types of income function the same on the FAFSA, as part of total income. This is similar to the treatment of distributions from retirement plans, where even a tax-free return of contributions from a Roth IRA is reported as income on the FAFSA.