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 balance rises and falls with the investment portfolios you pick inside it. “Non-qualified” means it sits outside any employer plan or IRA, so there is no federal contribution limit and no deduction when you fund it. “Variable” means the insurer does not promise a fixed return: you carry the market risk, and in exchange your earnings grow tax-deferred until you take money out.

How the Contract Is Funded

You pay the premium with dollars you have already been taxed on. Because the contract is a private agreement between you and an insurance company rather than a qualified retirement plan, it isn’t subject to participation rules, nondiscrimination testing, or annual IRS contribution caps. Anyone who meets the insurer’s requirements can buy one, regardless of income or employment status.

The IRS sets no ceiling on how much you can put in. That’s a meaningful contrast with IRAs, which cap contributions at a few thousand dollars a year. ¹ The practical limits come from the insurer. Most companies require a minimum initial premium, commonly somewhere between $1,000 and $10,000, and may cap total contributions based on your age and the specific product.

This is why people often turn to a non-qualified annuity after they’ve already maxed out their 401(k) and IRA and still have a large sum, from an inheritance or a property sale, that they want to grow on a tax-deferred basis.

Where Your Money Actually Goes

Inside the contract, your premium is allocated to sub-accounts that behave much like mutual funds. You choose from a menu of portfolios holding stocks, bonds, money market instruments, or a blend. The insurer holds these assets in separate accounts, walled off from its own general corporate funds, so your results track portfolio performance rather than the insurer’s balance sheet.

If your sub-accounts lose value, your account balance drops with them. Strong performance lifts it. You can usually reallocate among the available options without triggering a taxable event, which is more flexibility than you’d get swapping mutual funds in a taxable brokerage account.

What It Costs

Variable annuities layer on several fees you won’t see in a plain brokerage account, and those fees compound year after year against the value of tax deferral.

Mortality and expense risk charge (M&E). Pays the insurer for guarantees like the death benefit and the option to annuitize. Deducted daily from sub-account values, and typically runs around 1.25% per year.²
Administrative fees. Cover recordkeeping and overhead. Some insurers charge a flat annual fee of $25 to $30; others deduct about 0.15% of your account value each year.²
Sub-account management fees. Each underlying portfolio charges its own 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, the insurer takes a cut. Surrender periods commonly last six to eight years, with the charge starting around 6% to 7% in year one and declining by roughly a percentage point each year until it disappears.

Stack M&E, administrative, and sub-account expenses together, and total annual costs on a traditional commission-based variable annuity often land between 2% and 3%. Lower-cost fee-based contracts exist, but you have to read the prospectus closely to find where the charges actually fall.

How Growth and Withdrawals Are Taxed

While money stays inside the contract, you owe nothing on dividends, interest, or capital gains. That deferral is the central tax advantage of the product and is governed by Section 72 of the Internal Revenue Code. ³

When you start pulling money out before annuitizing, the IRS uses a last-in, first-out rule. The first dollars you take are treated as taxable earnings, not as a return of what you originally put in. ³ Only after you’ve withdrawn all the 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. Hold the same investments in a regular brokerage account and qualifying gains would be taxed at the lower capital gains rate; hold them in a non-qualified annuity and they won’t. The insurer reports distributions on Form 1099-R, which shows the gross amount and the taxable portion. ⁴

The 10% Early Withdrawal Penalty

Take money out before age 59½ and the IRS tacks on a 10% penalty on the taxable portion. ³ That’s on top of the ordinary income tax and any surrender charge the insurer imposes. All three can hit the same withdrawal.

Section 72(q)(2) waives the penalty in a handful of situations:

You are 59½ or older.
Distributions go to beneficiaries after the owner’s death.
You become unable to perform any substantial gainful activity because of a medically determinable impairment expected to last indefinitely or result in death.
You take substantially equal periodic payments based on your life expectancy (or the joint life expectancy of you and a beneficiary), at least annually. Once you start, you generally must continue for the longer of five years or until you reach 59½.
Payments come from an immediate annuity you begin receiving right after purchase.

Note what’s not on the list. Many of the penalty exceptions available for IRAs and 401(k)s, such as first-time home purchases, higher education expenses, and medical costs, do not apply to non-qualified annuity contracts. ³ For someone under 59½ who needs ongoing access without the penalty, the substantially equal periodic payments route is usually the only practical way out.

Turning the Account Into Income

At some point you may convert the contract into a stream of regular payments, a step called annuitization. Once you annuitize, the tax math changes. Instead of the LIFO rule, each payment is split into a taxable portion and a tax-free return of your investment using an exclusion ratio. ⁵

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

Once you’ve recovered your entire cost basis through those excluded portions, every payment after that becomes fully taxable. Annuitization locks in a predictable income stream, but you typically give up access to any remaining lump sum.

Switching Contracts Without Triggering Tax

If you find a contract with lower fees or better investment options, you don’t have to cash out to move. A Section 1035 exchange lets you swap one non-qualified annuity for another without recognizing gain, provided the transfer goes directly between insurers. ⁶ The contract owner has to stay the same, and the old cost basis carries over to the new contract. The old contract’s surrender charge may still apply, and the new one typically starts a fresh surrender period.

No Required Minimum Distributions

Unlike IRAs and 401(k)s, non-qualified annuities don’t force you to begin taking money out at any particular age. There’s no RMD schedule because the contract sits outside the qualified retirement plan system. You can leave the balance growing tax-deferred for as long as you like during your lifetime.

The longer you defer, though, the larger the taxable gain gets, and all of it comes out as ordinary income. If your heirs inherit the contract, they’ll owe income tax on the accumulated earnings without the benefit of a step-up in basis.

What Happens When the Owner Dies

When the contract owner dies, the insurer pays the named beneficiaries. Most non-qualified variable annuities include a standard death benefit guaranteeing beneficiaries at least the total premiums paid minus prior withdrawals, even if the sub-accounts have lost value. Enhanced death benefits are available on some contracts for an added fee that increases the M&E charge.

Beneficiaries owe ordinary income tax on the portion of the payout that exceeds the original cost basis. ⁷ Depending on the contract, they may take a lump sum, spread payments over five years, or annuitize over their own life expectancy.

One critical difference from other inherited assets: annuities do not get a step-up in cost basis at death. Federal law specifically excludes Section 72 annuities from the general step-up rule. ⁸ Invest $200,000, leave a contract worth $350,000 at death, and your beneficiary owes income tax on the full $150,000 of gain. Inherited stocks in a taxable account would reset to the date-of-death value and shed that tax entirely. This is one of the most overlooked drawbacks of holding large sums in a non-qualified annuity late in life.

Because the contract has a named beneficiary, the payout passes directly outside probate. That speed doesn’t reduce the income tax bill, but it does simplify the transfer.

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. Publication 575 (2025), Pension and Annuity Income
8
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent