Qualified vs. Non-Qualified – I Don’t Get It?!

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Published by Teresa Milner

If you’ve ever engaged in a conversation about retirement and you heard the terminology of qualified vs. non-qualified but you had no clue what that meant – know you’re not alone! The following is a basic explanation of the difference:

Qualified investments are accounts that are most commonly known as retirement accounts and they receive certain tax advantages when the money is deposited into the account. The contributions into a qualified investment account offer the following benefits:

  • The contributions can be deducted from your taxable income in the year they are made;
  • The contributions and earnings from the investment can be delayed as taxable income until they are withdrawn {tax-deferral}; and
  • Keeping these contributions in a qualified account allows the owner to delay paying the taxes until the year after they turn age 70.5, at which time Required Minimum Distributions (RMD) begin.

Non-qualified investments are accounts that do not receive preferential tax treatment. You can invest as much or as little as you want in any given year, and you can withdraw at any time. Money that you invest into a non-qualified account is money that you’ve already received through income sources and paid income tax on it.

Click here to download our guide to “8 Legitimate Tax Loopholes You May Be Missing.”

When you withdraw money from these accounts, you only pay tax on the realized gains (i.e. interest, appreciation etc). The amount of money you invest into a non-qualified account is considered the cost basis of that account.  When you withdraw the cost basis, you are not taxed on it again, as you already paid income tax on it.

The value in your account that is above the cost basis represents a stock appreciation. For example, you invest $100, and in a year’s time, you’ve earned $10 on that investment. Your balance in that non-qualified account is now $110; $100 is your cost basis and $10 is the appreciation.

So why does one need qualified and non-qualified accounts? Basically it boils down to a couple of reasons: taxation and flexibility. I’d like to share a couple of examples with you.

Consider an individual that was ready to retire. This individual hadn’t worked with a financial advisor at any point during their working career. They diligently contributed to their 401k, contributing the maximum amount they could each year. Upon retirement, all of the assets were in a qualified account.

In other words, they rolled the 401k over into an Individual Retirement Account and were ready to start living off of the 401k savings. This individual had nearly $2,000,000 in their IRA; a commendable accomplishment for their career! Now the individual is considering building a garage for personal use in 2016 at the cost of $65,000.

Without having any sizable investment accounts outside of their IRA, the individual simply assumed they would use some money from the IRA for the garage. In order for the individual to net the full $65,000 for the garage, they would have to withdraw substantially more than the $65,000, as they would need to pay taxes on every dollar withdrawn.

Had the individual also been saving in a non-qualified investment account during their working years, they could have had the flexibility of withdrawing funds from that account, and not have the big impact on the taxable income for 2016.**

Also consider another individual interested in performing a Roth IRA conversion. The reason they were interested in doing a Roth conversion was to lower their taxable income for the year.  The individual converted a portion of their IRA to a Roth, and paid income tax on the amount converted. The individual now has an additional bucket of money from which they will have flexibility to pull from later in life.  A Roth is considered similar to a non-qualified account in the fact that this is money that income taxes have already been paid on.**

You might be asking yourself, “Do I need both qualified and non-qualified accounts?” That’s a good question to ask your wealth advisor. In most cases, I suggest you strive to build a balance of qualified vs. non-qualified investment accounts for your future. You will provide yourself with so many more options and much more flexibility in retirement.

Click here to download “8 Blunders to Avoid in Retirement.”

* This material is for general information only and is not intended to provide specific advice or recommendations for any individual.  To determine what is appropriate for you, consult a qualified professional.  No strategy assures success or protects against loss.  This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified advisor.

** This is a hypothetical example and is not representative of any specific situation. Your results will vary.

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