Which account buys the annuity decides how much of every payment Medicare counts as income
Every explainer on qualified versus non-qualified annuities covers the tax timing. Almost none of them follows the check two years forward, into the income figure that sets Medicare premiums. Same contract, same $7,815 a month — funded from a 401(k) it triggers surcharges every year from 67; funded with after-tax money, nothing until 84.
One client buys an immediate annuity at 65. Premium of $1,250,000, payout of $7,815 a month for life, $93,780 a year. Run him two ways. In the first scenario the premium rolled out of his 401(k) — a qualified annuity. In the second he paid with after-tax savings — a non-qualified annuity. Nothing about the contract changes; only the account that bought it.
Every explainer on qualified versus non-qualified annuities covers what that difference means at tax time, and the tax-time version is short. Qualified annuities are bought with pre-tax dollars inside a retirement plan, so every payment is fully taxable. Annuities bought with after-tax money return the buyer's own cost tax-free, so only the growth is taxable. Both grow tax-deferred, and an insurance company will issue the identical contract either way.
Almost none of those explainers follows the check two years forward, into the income figure that sets Medicare premiums. That is where the two scenarios stop looking alike, and it is the part most retirement planning leaves out.
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 what Medicare counts, every year, for twenty years.
In the projection below — one client, one Social Security benefit, one leftover 401(k), everything identical except the account the premium came from — the qualified scenario pays a Medicare premium surcharge — IRMAA, the income-related monthly adjustment amount — every year from 67, the first year the annuity check sits in the two-year lookback. The non-qualified scenario 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.
One more thing the explainers leave out: where that surcharge is paid from. IRMAA surcharges, Part B and Part D alike, are withheld from the Social Security payment before it is deposited. Both scenarios pay the identical standard premium, so every surcharge dollar in this article is Social Security this client earned and does not receive.
A qualified annuity is an annuity bought with money that is inside a tax-advantaged retirement account: a 401(k), a 403(b), a traditional IRA. The money went in before tax, so the owner has no cost in the contract, and every dollar that comes out is taxable.
The word comes from the plan, not the contract. IRS Publication 575 describes a qualified employee plan as one that "meets Internal Revenue Code requirements," and in everyday use the label covers IRAs too. (Roth accounts and after-tax contributions are the exceptions to the fully-taxable rule. This article means the ordinary pre-tax case.)
Qualified annuities come in the same forms as any other annuities: immediate or deferred, fixed, indexed or variable. The label says nothing about the product, only about the retirement plan that owns it.
A non-qualified annuity is an annuity bought directly from an insurance company with money that has already been taxed: savings, a brokerage account, the proceeds of a sale. It sits outside any retirement plan. The premium is the owner's cost — the IRS calls it the investment in the contract — and it comes back tax-free. Only the growth is taxable. "Non-qualified" does not mean lesser or non-compliant. It means only that no retirement plan is involved.
Both kinds of annuities grow tax-deferred, and both can pay a check for life. The label describes the money that bought the contract, not the contract itself. The same insurer can issue the same annuity, with the same payout, as either one. That is why the client here can be run both ways — and why the rest of this article is about what the label does to the check.
Annuities are insurance contracts. A life insurance company issues them, and the tax code treats the growth inside them the same way whether the contract is qualified or not: nothing is taxed until money comes out. That tax-deferred growth is the one feature qualified annuities and non-qualified annuities share. Everything else follows from which dollars bought the contract. That holds for every form annuities take, from a fixed immediate annuity to a variable deferred one.
Qualified annuities are funded with pre-tax dollars: a rollover from a 401(k), a transfer inside a traditional IRA, contributions to a 403(b). The retirement account already defers tax, so qualified annuities add no second layer of deferral. What they add is the insurance company's promise of a payment for life. Because nothing in the contract has been taxed, every dollar that comes out is fully taxable. Qualified annuities also follow the rules of the retirement plan that holds them: annual contribution limits, and required minimum distributions (RMDs) that begin at 73 today and at 75 for anyone born in 1960 or later.
Non-qualified annuities are funded with dollars that have already been taxed, so the tax code reaches only the growth. It sets no limit on the premium, and the lifetime RMDs that govern retirement plans do not apply. How the growth is taxed depends on how the money comes out. Annuitize, and each payment is split between taxable earnings and a tax-free return of cost, using the exclusion ratio worked through below. Take a withdrawal instead, and the amount counts as earnings first, fully taxable until the gain is gone. Either way, gain from annuities is ordinary income, never capital gain. (The IRS writes "nonqualified annuities"; most of the insurance industry hyphenates. Same contracts.)
That is the trade annuities make against what a client already owns. Mutual funds in a taxable account distribute dividends and capital gains that are taxed in the year they are paid, reinvested or not, so they show up in MAGI every year, though partly as capital gain. Annuities keep the growth out of MAGI until the client takes it, then tax all of it at ordinary rates, with no step-up in basis for heirs. Life insurance sits at the other end: the death benefit generally reaches the beneficiary free of federal tax, and a life insurance policy can be exchanged for an annuity tax-free under §1035, though an annuity cannot be exchanged for life insurance.
One difference rarely makes the comparison tables. Payments and withdrawals from non-qualified annuities count as net investment income, exposed to the 3.8% surtax once MAGI passes $200,000 for a single filer or $250,000 on a joint return. Distributions from qualified annuities do not, although they still raise the MAGI that decides whether the surtax applies to the rest of the client's investments.
At the owner's death the two kinds of annuities part ways again. Non-qualified annuities follow §72(s): if payments have not started, the contract must be paid out within five years, unless a named beneficiary starts taking it over his or her life expectancy within one year, or a surviving spouse continues the contract as the new owner. Qualified annuities follow the rules for retirement accounts instead. For most non-spouse heirs since 2020, that means the account must be emptied by the end of the tenth year.
Telling them apart is a paperwork question. Qualified annuities are titled as an IRA or held inside an employer plan, and their distributions arrive on a Form 1099-R with the IRA box checked. Payments from non-qualified annuities arrive on a 1099-R with distribution code D. None of this makes one kind better. For retirement planning it means the same contract behaves as two different financial instruments, depending on the account behind it. The rest of this article is about the place where that difference gets expensive, and where almost no financial plan looks: the Medicare premium.
The standard comparison of these annuities 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.
| Factor | Qualified annuities | Non-qualified annuities | What reaches Medicare |
|---|---|---|---|
| Funding | Pre-tax (IRA, 401(k)) | After-tax | Sets which of the next four rows applies |
| Growth | Tax-deferred | Tax-deferred | Nothing, until money comes out |
| Payments | 100% taxable | Earnings only (exclusion ratio), until the cost is recovered | 100% of the check vs. the earnings share — one-third here |
| Required distributions | Yes | None during the owner's life | Qualified money is forced into MAGI on a schedule; after-tax money is not |
| Early withdrawal (before 59½) | 10% on the whole amount (no cost basis) | 10% on earnings only | Same split: the penalty rides on the taxable portion, and so does MAGI |
| At death | Fully taxable to the heir | Gain only | The heir's MAGI — and, if the heir is on Medicare, the heir's surcharge |
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, the spine of MAGI.
Non-qualified, annuitized. In that scenario the client 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 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 moving part is on the table, so here is all of it.
The two paths. In the qualified path, the $1,250,000 came out of the 401(k), so the annuity is funded with pre-tax dollars 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. In that scenario he 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 which version of him 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 IRMAA surcharges through 90: $0. That is what lets the charts below attribute every dollar to the check. It is not the only alternative to the qualified scenario: 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 MAGI 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 taxable annuity payments 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 scenario'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 after-tax 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 that path's total at $133,872 instead of the software's $68,663.
From 67 to 90 the qualified path pays $363,772 in IRMAA 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. Because the surcharge is withheld from the Social Security deposit and the standard premium is the same in both scenarios, that $229,899 is Social Security net benefit the qualified scenario never receives.
One thing to say plainly before the caution. In the qualified scenario he was always going to owe 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 after-tax scenario buys, 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 scenario still pays a surcharge every year from 67 — in the first tier rather than the second, $144,993 in total — and the after-tax scenario pays nothing until the exclusion ends, then the same four years: $43,238. At 2.8%, the qualified scenario pays $14,098 over five years and the after-tax scenario 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 control 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 MAGI.
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 a client who holds both kinds of money, that makes annuities a retirement planning question before they are an insurance question.
For an advisor weighing annuities inside a financial plan, the checklist is short.
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 immediate 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 second 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 that path are corrected to the IRS rule. Ages 65 and 66 are not modeled (no pre-retirement earnings 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.
Annuities are a placement decision as much as a product decision. The fastest way to see which account should fund one is to run a real client both ways. Book a session below and we will project the client's MAGI against the thresholds that will price the premiums, once as a qualified annuity and once with after-tax money, during the call.
Model a client's annuity both ways, live
Then keep going: the rules that decide what a retiree pays for Medicare, and the financial planning moves, annuities among them, that change it.
Disclaimer: This article is educational content for financial professionals. It is not investment, tax, legal, insurance, or accounting advice, and it is not a recommendation of any security, strategy, or product. Any examples, figures, and calculations are hypothetical illustrations based on the stated assumptions and on tax and Medicare rules in effect at the time of writing, which are subject to change; they are not predictions or guarantees, and individual results will differ. RetirementAdvisorPro is not a registered investment adviser, broker-dealer, insurance agency, law firm, or accounting firm, and nothing here creates an advisory or professional-client relationship. Consult a qualified financial, tax, or legal professional regarding your specific circumstances. See our full disclosures.
Co-Founder of IRMAA Certified Planner, Founder of RetirementAdvisorPro
Mark Annese is an IRMAA Certified Planner specializing in helping financial advisors navigate Medicare income-related adjustments and optimize client retirement income strategies.
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