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Annuities come in many different forms. There are immediate and deferred annuities, with both fixed and variable rates. However, whatever the type of annuity, all can be classified as either qualified or nonqualified annuities. And the distinction is easy.

Qualified annuities are used in connection with tax-advantaged retirement plans, such as 401(k) plans, Section 403(b) retirement plans (TSAs), or IRAs. Premiums for qualified annuities are generally paid with pretax dollars.

By definition, any annuity not used to fund a tax-advantaged retirement plan or IRA is considered a nonqualified annuity. Contributions to nonqualified annuities are made with after-tax dollars--premiums are not deductible from gross income for income tax purposes.

In essence, then, the products are the same. It is the placement in or out of a retirement plan (and the resulting tax treatment) that distinguishes one from the other.

As noted, contributions to a qualified annuity may be deductible to the individual or employer (and/or excludable from the income of the individual) at the time of contribution.

When an annuity is in a retirement plan, the rules of the plan govern all tax matters. Specifically, the special tax-deferral advantages of annuities, and the unique tax penalties and tax treatment of annuities at distribution, are superseded when used in a retirement plan by the tax rules governing all investments in such plans.

Note: Although it is true that the tax-deferral advantage of annuities is redundant in a qualified plan, annuity products may offer other features, such as a guaranteed death benefit and income for life, that may make them a viable investment option for a portion of a qualified plan portfolio.

Note: Annuity guarantees are subject to the claims-paying ability of the annuity issuer.

The rules for nonqualified annuities are different in many respects, because these products are purchased with after-tax money.

If the nonqualified annuity is partially or fully surrendered, the first dollars out are considered earnings, and all of the earnings are taxed at ordinary income rates. After all of the earnings have been distributed, the remaining portion that represents the original investment in the annuity is received tax free.

If payments are taken in the form of an annuity payout (i.e., a distribution taken out over a predetermined period of time), a portion of each payment is considered a return of the original investment and is excludable from gross income, and a portion is considered earnings and taxed at ordinary income tax rates.

The percentages that are earnings and return of investment are based on the type of payout at the age of the recipient. Note, too, that distributions taken before age 59½ are subject to a 10 percent early withdrawal penalty tax on earnings.

Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including the possibility of loss of principal. Variable annuities are sold by prospectus, which contains information about the variable annuity, including a description of applicable fees and charges. These include, but are not limited to, mortality and expense risk charges, administrative fees, and charges for optional benefits and riders. The prospectus can be obtained from the insurance company offering the variable annuity or from your financial professional. Read it carefully before you invest.