Qualified vs. Non-Qualified Annuities: Same Check, Different Medicare Bill

Two clients buy the same income annuity at 65. Same premium of $1,250,000, same payout: $7,815 a month for life, $93,780 a year. The only difference is the money that bought it. One rolled it out of a 401(k). The other paid with after-tax savings.

Every explainer on qualified versus non-qualified annuities covers what that difference means at tax time. Almost none of them follows the check two years forward, into the income figure that sets Medicare premiums. That is where the two clients stop looking alike.

The qualified check puts $93,780 a year into the income Medicare counts. The non-qualified check puts in $31,323. Same deposit, $62,457 of difference in Medicare income, every year, for twenty years.

In the scenario modeled below — one retiree, one Social Security benefit, one leftover 401(k), everything identical except the label on the annuity — the qualified buyer pays an income-based Medicare surcharge every year from 67, the first year the annuity income sits in the two-year lookback. The non-qualified buyer pays nothing until 84. And the same Social Security and leftover 401(k), with no annuity, pay no surcharge in any modeled year. Every surcharge dollar in the charts is the check's.

The standard comparison has five rows. Here they are, with one more column: how much of the money lands in the modified adjusted gross income (MAGI) that Medicare uses to set surcharges two years later.

Sources: IRS Publication 575 (fully taxable payments; earnings-first withdrawals), Publication 939 (exclusion ratio; recovery of cost), 26 U.S.C. §72(t) for qualified plans and IRAs and §72(q) for non-qualified contracts — both apply the 10% additional tax only to "the portion of such amount which is includible in gross income."

Qualified. The IRS rule is one sentence: if you "didn't pay anything or aren't considered to have paid anything" for the annuity — and pre-tax contributions do not count as paying — every payment is fully taxable. A direct rollover keeps that zero basis. All $93,780 goes into adjusted gross income, and adjusted gross income is the spine of MAGI.

Non-qualified, annuitized. The buyer already paid tax on the $1,250,000, so part of every check is that cost coming back. The IRS splits each payment with an exclusion ratio: investment in the contract, divided by expected return, rounded to three decimals. Expected return is the annual payment times a life-expectancy multiple from Publication 939's Table V — 20.0 at age 65.

For this contract: $1,250,000 ÷ ($93,780 × 20.0) = $1,250,000 ÷ $1,875,600 = 0.66645, which Publication 939's three-decimal rounding makes 0.666 — 66.6% excluded. Of each year's $93,780, $62,457 is return of cost, excluded from gross income, and $31,323 is taxable. Every figure in this article uses that IRS split.

Two limits on that split. The first is from the same publication: the exclusion ends once the full $1,250,000 has come back — twenty years of payments (240 checks) recover $1,249,150, the first check of the twenty-first year takes the last $850, and "thereafter, your annuity payments are fully taxable." The second is from Publication 575 and §72(e): the split applies only to annuitized payments. Withdrawals from a deferred non-qualified contract issued after August 13, 1982 are allocated to earnings first, fully taxable until the gain is gone.

Then Medicare looks back. IRMAA is a cliff, set on MAGI from two years prior, against income thresholds that start at $109,000 for a single filer in 2026. Cross a line by a dollar and the whole tier applies. So $62,457 a year of difference between the two checks is not a rounding error. It is more than a full bracket of headroom. The lookback itself is the mechanism behind how a Roth conversion changes the Social Security deposit and why the same charitable gift can cost $2,296.80 or nothing.

Nothing below works unless every income source is on the table, so here is all of it.

• The client. Single, born 1970 (56 this year), retiring at 65, projected to 90.
• Social Security. A $3,900 full-retirement-age benefit, reduced to $3,380 a month for claiming at 65 — $40,560 a year to start, with a 2% cost-of-living adjustment. With the annuity, 85% of it is taxable. Without the annuity, 58% is — which is why the no-annuity income figure below is $59,438 rather than $70,476.
• The 401(k). $1,000,000 today, $1,000 a month going in until 65, growing at a constant 7%. The projection puts it at $2,073,935 at 65. (Ten full years of annual compounding would give about $2.13 million; the software projects from mid-2026 and grows the partial year.)
• The annuity. At 65 he moves $1,250,000 — about 60% of the balance — into a single-life income annuity paying $7,815 a month for life. Life only: no refund, no period certain. That structure was chosen because it is the published third-party estimate for a 65-year-old man (April 2026, scaled from a $250,000 quote — about 7.5% of premium) and because a refund feature would lower the payout and change the exclusion ratio.
• What stays. $823,935 remains in the 401(k). He draws $3,000 a month from it starting at 65. Required minimum distributions begin at 75 and replace the $3,000 draw once they are larger ($42,821 that first year).
• What the model does not do. The annuity check is fixed in nominal dollars for 25 years, as an immediate annuity's is. The 401(k) earns a constant 7% with no bad years. Ages 65 and 66 show no surcharge only because the software has no pre-retirement earnings to look back on; everything this article claims runs from 67. Part D enrollment is assumed.

The two paths. In the qualified path, the $1,250,000 came out of the 401(k), so the annuity is pre-tax money and the whole check is taxable. In the non-qualified path the client holds the same Social Security and the same $823,935 in the 401(k) at 65, but the $1,250,000 came from an after-tax account instead. That second client started with less in his 401(k) and $1.25 million outside it — money he had already paid income tax on. The comparison is not about who was richer at 56; it is about what happens to the identical check from 65 on.

The control. Run the same client with no annuity at all — Social Security plus the $823,935 401(k), its withdrawals and its required distributions — and his MAGI starts at $59,438 and stays under the first surcharge threshold in every year to 90 (he would cross it at about 92). Lifetime income-based surcharges through 90: $0. That is what lets the charts below attribute every dollar to the check. It is not the qualified buyer's only alternative: had he left the $1,250,000 in the 401(k), required distributions would have pushed that money into MAGI on their own schedule and produced surcharges of their own. This comparison isolates the check, not the decision to buy.

MAGI at 65, the first year Medicare will look back on: no annuity $59,438 · non-qualified $101,799 · qualified $164,256. The annuity adds more than its own taxable share, because it also pulls $11,038 more of Social Security into the taxable column: $104,818 of MAGI in the qualified path, $42,361 in the non-qualified path. The gap between them is the $62,457 exclusion.

Read the qualified path first. His MAGI at 65 is $164,256 — Social Security, the $36,000 401(k) withdrawal, and the whole annuity check. Two years later that year's income sets his premium, and it sits above the second threshold, which by then has been indexed to $152,847. Surcharge at 67: $6,139. He stays in that tier every year to 90, where the surcharge is $29,984 and the total is $363,772. At 90 he is $387 under the third line; the projection ends before he crosses it.

The non-qualified path has the same Social Security, the same withdrawal, and $31,323 of annuity income instead of $93,780. MAGI at 65: $101,799, well under the first line. Surcharge at 67: $0. Through 83: $0. The slow climb of Social Security COLAs and required distributions lifts him over the first threshold at 84 — by $1,440, for a surcharge of $7,896 that year.

Then the exclusion ends. After twenty years of payments, at 85, the $1,250,000 has come back to him all but $850, and from 86 the IRS taxes the entire check. His MAGI matches the qualified client's, and two years later — at 87 — so does his surcharge. For the last four years of the projection the two paths pay the same $24,370 to $29,984 a year. (Had he died before 85, the unrecovered cost would have been deducted on his final return instead.)

That tail matters. The non-qualified advantage is large, but it is not permanent, and any illustration that shows the split lasting forever is wrong. The projection software applies the exclusion indefinitely; the figures here are corrected to the IRS rule, and the correction is what puts the non-qualified total at $133,872 instead of the software's $68,663.

From 67 to 90 the qualified path pays $363,772 in income-based surcharges and the non-qualified path $133,872: a difference of $229,899 for the identical check, relative to the same Social Security and the same remaining 401(k). Years with a surcharge: 24 versus 7.

One thing to say plainly before the caution. The qualified buyer was always going to owe income tax on that $1,250,000. The surcharge is a second bill on the same dollars, and it lands whether the money comes out as an annuity check, a withdrawal, or a required distribution. What the non-qualified buyer bought, with money already taxed once, is twenty years in which two-thirds of the check is invisible to Medicare.

Now the caution. Those totals rest on two assumptions that sit underneath every long-range Medicare projection, and both lean the same way. The model indexes the IRMAA thresholds at 1% a year, slower than their history: the statute indexes them to inflation, which has run closer to 2.5% to 3%. And it grows the Part B premium at 7.3% a year, faster than its roughly 4% to 6% long-run average, depending on the window. Bring either back to history and the totals shrink. Re-run at 2% threshold indexing, the qualified client still pays a surcharge every year from 67 — in the first tier rather than the second, $144,993 in total — and the non-qualified client pays nothing until the exclusion ends, then the same four years: $43,238. At 2.8%, the qualified client pays $14,098 over five years and the non-qualified client pays nothing.

So the direction does not move: the qualified check crosses a line and the non-qualified one does not. The size of the bill moves a great deal, and every knife edge in this scenario — the $1,440 margin at 84, the $387 margin under the third tier at 90, the no-annuity client crossing at 92 — is a reminder that a projection to 90 is a projection to 90. The durable numbers are the $62,457 a year of MAGI difference, the 100%-versus-one-third split, the two-year lookback, and the cliff. Those are statute. The lifetime dollar figure is an assumption stacked on those facts, and a client conversation should present it that way.

Required distributions. A qualified annuity is retirement-plan money; once it is annuitized the payments satisfy the required distribution for that portion, but the point stands that the money was always going to be forced into MAGI on a schedule. A non-qualified contract has no required distributions during the owner's life. The client decides when — and whether — its earnings ever reach Medicare's income figure.

Early withdrawals. Before 59½ the 10% additional tax applies to "the portion of such amount which is includible in gross income" — the whole withdrawal on a qualified contract, because there is no cost basis, and earnings only on a non-qualified one. The qualified rule is §72(t), with its own exceptions such as separation from service at 55; the non-qualified rule is §72(q). Rarely an IRMAA question, since the client is usually years from Medicare, but it is the same split, and it is why the two contracts behave differently in every year of their lives.

Beneficiaries. The life-only contract modeled here pays nothing at death — that is the trade for the payout rate, and it is why the heirs in either path inherit the 401(k) remainder, not the annuity. For a deferred contract or one with a refund feature the rule is: a qualified annuity passes fully taxable to the heir; a non-qualified one passes the gain only, as income in respect of a decedent. The Medicare angle is the heir's, not the decedent's: a 66-year-old child who inherits a qualified contract and takes it as a lump sum has just put the whole thing into her own MAGI, and her own premium two years later. The same logic that drives the widow's penalty — one person, single thresholds, inherited income — applies to the next generation too.

Contribution limits. Annual contributions to qualified accounts are capped; a rollover of an existing balance, as here, is not, which is how a $1,250,000 qualified contract is possible. Premiums for a non-qualified contract are never capped. Through the IRMAA lens that cuts the other way from how it reads: the uncapped pool is the one whose payments come out mostly excluded, so for a client building toward an annuity with new money, the account that can take more is also the one whose check Medicare counts least.

None of this says a client should own an annuity, or which kind, or that annuitizing 60% of a 401(k) into a life-only contract is a good idea — that size and structure were chosen so the effect would be visible on one client with nothing else behind it. It says that if an annuity is going to be bought, which account buys it is a decision with a Medicare price attached, and most illustrations never show that price because it lands two years after the purchase and on a different statement. The same dollars cannot be both: a 401(k) rollover stays qualified, and no election turns pre-tax money into after-tax money. The choice is only ever which pool funds the contract.

For an advisor, the checklist is short.

• Compute the exclusion ratio before the client signs. Premium ÷ (annual payment × the Table V multiple), rounded to three decimals. That is the share of every check that will not reach Medicare's income figure — and the year it stops.
• Project MAGI two years forward from the first payment, both ways, against the tiers as they will be indexed in that year. Look for the client whose check is wider than the room he has under a line.
• If the contract is non-qualified and deferred, decide up front whether it will be annuitized or drawn down. Withdrawals are earnings-first and fully counted; only annuitized payments get the split.
• Present any lifetime surcharge figure with its indexing and premium-growth assumptions attached. The mechanism is durable; the total is not.

Modeled in RetirementAdvisorPro: single filer, born 1970, retiring at 65, projected to 90. $3,900 full-retirement-age Social Security benefit claimed at 65 ($3,380 a month, $40,560 a year) with a 2% cost-of-living adjustment. $1,000,000 401(k) at a constant 7% with $1,000 monthly contributions until 65, projected at $2,073,935; $1,250,000 of it buys a single-life, no-refund income annuity paying $7,815 a month (a published third-party estimate for a 65-year-old male, April 2026, scaled from $250,000); the remaining $823,935 stays, with $3,000 monthly withdrawals from 65 replaced by required distributions from 75 once larger. The software cannot remove a lump sum at 65, so the remainder is modeled as a 401(k) that reaches $823,939 at 65 on the same contributions and return — a $4 rounding difference. In the non-qualified path the identical annuity is funded from an after-tax account and the 401(k) is identical. Non-qualified split per IRS Publication 939: 66.6% excluded ($62,457 a year), $31,323 taxable, cost recovered after 20 years of payments; the software applies the exclusion indefinitely, so ages 85 to 90 in the non-qualified path are corrected to the IRS rule. Ages 65 and 66 are not modeled (no pre-retirement income in the lookback). Part B premiums assumed to grow 7.3% a year, Part D 6%, IRMAA thresholds 1%; Part D enrollment assumed. A higher threshold assumption or a lower premium-growth assumption shrinks every surcharge figure; neither changes the exclusion ratio, the lookback, or the cliff.