When it comes to investments, there are generally two types – Qualified and Non-qualified. So what exactly do these two terms mean? They specifically relate to the tax treatment of the investment, or in simpler language, how the investment is taxed.
A Qualified investment is one where the taxes on the invested dollars and interest earned have NOT been paid yet. The most common examples of this would be your 401k, 403b, Individual Retirement Account (IRA), or an employer profit sharing plan. All of these plans work in the same basic way – money earned by you is invested into a qualified account on a pre-tax basis. This means that no taxes have been paid and the investment earns interest over time on a tax-deferred basis.
Several important notes to consider before using a qualified investment account. First, the money is intended specifically for retirement and as such has very strict guidelines surrounding its use – specifically, a ten percent penalty tax for withdrawing money prior to age 59 ½. Additionally, there is a prerequisite for mandatory withdrawals, called Required Minimum Distributions or RMD’s from the account starting at age 70 ½ with HUGE (up to 50 percent!) penalties if you do not comply. Finally, there are annual contributions limits to all qualified accounts and there may be income limitations based on your plans design.
The advantage of using a qualified investment account is that you are able to utilize more of your money for your investment, because no taxes have been paid thereby leaving a larger amount of your earnings available. Furthermore, the tax-deferral on future earnings means that the account grows at a faster pace versus investments that have to pay taxes as interest is earned or prior to the investment being made. Additionally, many qualified accounts – specifically 401k and profit sharing plans may include an employer matching contribution or additional investment provided by the employer as part of the qualified plan.
With a Non-qualified investment, taxes are paid prior to the investment being made. The advantage of these plans is that the post-tax money invested is considered the cost basis of the investment. The cost basis of the investment is the portion that will not be taxed again as interest is earned or withdrawals are made.
How and when taxes are paid on non-qualified accounts can be tricky. Like qualified investments, the money in some non-qualified accounts can earn interest on a tax-deferred basis. This tax-deferral allows the investment to grow on a compounding basis, allowing the money to accumulate faster. This is most common on annuity and cash value life insurance products. Other non-qualified investments like stocks and mutual funds don’t pay taxes until the underlying investment asset is sold. Non-qualified investments like Bonds, CD’s, and savings accounts pay taxes annually on the interest they earned during the previous year.
Several key benefits to non-qualified plans are their open design, lack of income or contributions limitations, and general ease of use. Additionally, there are no requirements for minimum distributions or tax penalties for withdrawals prior to age 59 ½.
There is one other category of investment account – the ROTH. A ROTH account is technically a qualified investment, but it acts more like a non-qualified asset in many ways. First, an investment in a ROTH account is made with post-tax dollars. Second the money is allowed to grow tax-deferred. And finally and most important, all subsequent gains are tax-free. I know, it almost sounds too good to be true, and in some ways it is. The biggest drawback to the ROTH account is the ROTH contribution and income limits that affect its use.
Obviously this is only a broad overview of the different investment options and account types available. It is however a good place to start on your financial planning and education. More importantly, because there are so many options when investing, it is vital to work with a true “Financial Professional” who can help you determine which type of investment meets your needs best. Don’t delay; there is never a good reason to wait on improving your financial future.