What Is a Non-Qualified Variable Annuity and How Does It Work?

A non-qualified variable annuity is an insurance contract you buy with after-tax money, where your account value rises and falls with the investment sub-accounts you pick inside the contract. “Non-qualified” means it sits outside any IRA or employer retirement plan, so there is no federal contribution limit and no deduction for what you put in. “Variable” means the insurer does not promise a fixed return; your balance moves with the market. Earnings compound tax-deferred until you withdraw them, and every dollar of gain comes out as ordinary income.

How the Contract Is Structured

The insurance company provides the platform: a menu of investment portfolios, a set of contractual guarantees, and the tax-deferred wrapper. You provide the money and carry the market risk. Because the contract is a private agreement between you and an insurer rather than part of a qualified retirement plan, it is not subject to participation rules, nondiscrimination testing, or annual contribution caps. Anyone who meets the insurer’s requirements can buy one, regardless of income or employment status.

The dollars you contribute have already been taxed, so you get no deduction going in. What you get instead is deferral: dividends, interest, and capital gains inside the contract are not taxed each year the way they would be in a regular brokerage account.

How Much You Can Contribute

The IRS sets no cap on contributions to a non-qualified annuity. That is a meaningful contrast with IRAs, which limit contributions to $7,000 per year, or $8,000 if you are 50 or older, for 2025.¹ For someone who has already maxed out qualified accounts and wants tax-deferred growth on a lump sum from an inheritance, a property sale, or years of savings, the absence of a federal ceiling is the main draw.

The insurer sets the practical boundaries instead. Most companies require a minimum initial premium in the range of $1,000 to $10,000, and many impose their own maximum contribution based on your age and the specific product.

Where the Money Is Invested

Inside the contract, your premium goes into sub-accounts that function much like mutual funds. Typical menus include stock portfolios, bond portfolios, money market options, and blended allocations. The insurer holds these assets in separate accounts, walled off from its general corporate funds, so your investment results depend on portfolio performance rather than the insurer’s balance sheet.

If your sub-accounts fall, your account value falls with them. If they rise, it rises. You can usually shift among the available sub-accounts without triggering a taxable event, which is more flexibility than you get swapping funds in a taxable brokerage account.

Fees You Will Pay

Variable annuities carry several layers of cost that compound year after year and offset some of the value of tax deferral. The main ones:

Mortality and expense risk charge (M&E), which pays the insurer for the death benefit and the option to annuitize. It is deducted daily from sub-account values and typically runs around 1.25% per year.²
Administrative fees for recordkeeping, often a flat $25 to $30 annually or roughly 0.15% of account value.²
Sub-account management fees charged by each underlying portfolio, similar to a mutual fund expense ratio. Passive index options can run 0.10% to 0.30%; actively managed portfolios often exceed 1.00%.
Surrender charges if you withdraw more than the contract’s free-withdrawal allowance during the early years. Surrender periods commonly run six to eight years, with the charge starting around 6% to 7% in year one and declining by roughly a point each year.

Stacked together, total annual costs on a traditional commission-based variable annuity often land between 2% and 3%. Lower-cost fee-based contracts exist; the prospectus is where you confirm what you are actually paying.

How Withdrawals Are Taxed

Earnings inside the contract grow without annual tax. Nothing is due on dividends, interest, or capital gains while the money stays in. This deferral is governed by Section 72 of the Internal Revenue Code.³

When you take money out before annuitizing, the IRS applies a last-in, first-out rule. The first dollars you withdraw are treated as taxable earnings, not as a return of the premium you paid in.³ Only after you have withdrawn the entire accumulated gain do further withdrawals become tax-free returns of your cost basis. Every taxable dollar comes out as ordinary income, not long-term capital gains. That is a real cost compared with holding the same investments in a regular brokerage account, where qualified dividends and long-term gains would be taxed at lower rates.

The insurer reports distributions on Form 1099-R, breaking out the gross amount and the taxable portion.⁴

The 10% Early Withdrawal Penalty

If you take money out before age 59½, the IRS adds a 10% penalty on the taxable portion.³ This is on top of the ordinary income tax you already owe, and separate from any surrender charge the insurer imposes.

Section 72(q)(2) lists several situations where the penalty does not apply:

Reaching age 59½.
Death of the contract owner, so distributions to beneficiaries are penalty-free.
Disability, defined as being unable to perform any substantial gainful activity because of a medically determinable physical or mental impairment expected to last indefinitely or result in death.
A series of substantially equal periodic payments based on your life expectancy, or the joint life expectancy of you and a beneficiary, taken at least annually. Once you start, you generally must continue for the longer of five years or until you reach 59½.
Payments from an immediate annuity you begin receiving right after purchase.

Several familiar IRA and 401(k) penalty exceptions, including first-time home purchases, higher education, and medical expenses, do not apply to non-qualified annuities.³ For someone under 59½ who needs steady access to annuity funds without a penalty, the substantially equal periodic payments route is usually the workable option.

Turning the Contract Into Income

You can convert the contract into a stream of regular payments, a process called annuitization. Once you annuitize, the tax math changes. Each payment is split between a taxable portion and a tax-free return of your original investment using an exclusion ratio.⁵

The formula divides your investment in the contract by your expected total return (the annual payment multiplied by the expected payout period from IRS life expectancy tables). The result is the tax-free percentage of each payment. If you invested $100,000 and your expected return is $250,000, the ratio is 40%: on a $1,000 monthly payment, $400 is tax-free and $600 is ordinary income.⁵

Once you have recovered your full cost basis this way, every later payment becomes fully taxable. Annuitizing locks in a predictable income, but you typically give up access to the remaining lump sum.

Switching Contracts Without Triggering Tax

If you want to move from one non-qualified annuity to another because of lower fees or better investment options, you do not have to cash out. Federal law allows a direct insurer-to-insurer exchange of one annuity contract for another without recognizing gain or loss.⁶ You can also exchange an annuity for a qualified long-term care contract under the same provision.

The contract owner must stay the same; a 1035 exchange cannot be used to move an annuity to a different person. Partial exchanges are permitted but receive closer IRS scrutiny. If you withdraw from or surrender either contract within 24 months of a partial exchange, the IRS may treat the whole transaction as a single taxable event, unless a qualifying life event such as disability, death, divorce, or reaching age 59½ occurred in between.⁷

Your original cost basis carries over into the new contract, so you are not resetting the tax clock. The old contract’s surrender charge may still apply, and the new contract typically starts a fresh surrender period.

No Required Minimum Distributions

Non-qualified annuities are not subject to the required minimum distribution rules that force IRA and 401(k) owners to start taking money out at a specific age. You can leave the balance growing tax-deferred throughout your life, which is part of the appeal for people who do not need the income and want to keep deferring tax.

The longer the deferral runs, the larger the eventual taxable gain, and all of it comes out as ordinary income. That matters most at the end, when heirs receive the contract.

What Happens When the Owner Dies

On the owner’s death, the insurer pays out to the named beneficiaries. Most non-qualified variable annuities include a standard death benefit guaranteeing that beneficiaries receive at least total premiums paid minus prior withdrawals, even if the sub-accounts have lost value. Because the contract names a beneficiary, the death benefit passes outside probate.

Beneficiaries owe ordinary income tax on the portion of the payout that exceeds the owner’s cost basis.⁸ Depending on the contract, they may take a lump sum, spread payments over five years, or annuitize over their own life expectancy.

One point often missed: annuities do not receive a step-up in basis at the owner’s death. Federal law specifically excludes annuities described in Section 72 from the general step-up rule.⁹ If you put in $200,000 and the contract is worth $350,000 at death, your beneficiary owes income tax on the full $150,000 of gain. The same investments held as stocks in a taxable account would reset their basis to date-of-death value, wiping out that tax. For someone considering a large non-qualified annuity late in life, this is one of the trade-offs worth weighing before signing.

1
Internal Revenue Service. Publication 590-A (2025), Contributions to Individual Retirement Arrangements (IRAs)
2
U.S. Securities and Exchange Commission. Variable Annuities: What You Should Know
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
5
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
6
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
7
Internal Revenue Service. Part I Section 1035 – Certain Exchanges of Insurance Policies
8
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
9
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent