As you plan your retirement or review your finances, you’re sure to come across the terms “qualified” and “non-qualified.” In their most basic definitions, non-qualified funds are funds you’ve already paid taxes on, and qualified funds are funds you haven’t paid taxes on.
Non-qualified
- Post-tax funds
- No taxes owed
- No tax advantages
Non-qualified accounts include savings and brokerage accounts. As for IRAs, we will get to them later.
Qualified
- Pre-tax funds
- Tax-deductible contributions
- Reduced taxable income
- Tax-deferred growth
When it comes to retirement planning, you are most likely putting into a qualified retirement plan through your work. A qualified retirement plan is a plan your employer sets up, which you fund with deductions from your paycheck. In some cases, your employer may also put into your plan. If you are self-employed and have a Solo 401(K), you are also putting into a qualified retirement plan. Essentially, any retirement plan that meets the guidelines of the Employee Retirement Income Security Act (ERISA) is considered ‘qualified.’
Enacted in 1974, ERISA aimed to safeguard employees’ retirement earnings while promoting transparency.
List of Qualified Retirement Plans
- 401(k) plans
- 403(b) plans
- profit-sharing plans
- Keogh (HR-10) plans
These plans vary widely in shape and form but share some key characteristics. They are tax-deferred, funds are accessible when you reach 59 ½, and you must begin withdrawing from them at age 73 if you reach age 72 after Dec. 31, 2022. Additional guidelines set out in ERISA include:
- Fiduciary responsibility of plan providers
- Minimum standards for participation
- Subject to nondiscrimination testing (plan can’t favor specific employees)
- Establishment of a grievances and appeals process
- It gives participants the right to sue for breaches of fiduciary duty
- Protection from creditors in most cases
ERISA gave Americans a safe tool to save for retirement in a controlled and safe environment with tax advantages.
What about IRAs?
IRAs are not qualified retirement plans because an employer doesn’t set them up. However, they share many of the same characteristics as their qualified counterparts. In fact, they were also created under ESIRA to encourage and aid Americans without a pension plan to save for retirement.
Traditional IRAs also utilize post-tax funds with tax-deferred growth. They lower your taxable income for the year you put into them and come with Required Minimum Distributions. These facts make their contributions as ‘qualified’ in a looser sense.
Roth IRAs, however, are post-tax funds, making them definitively non-qualified. However, we can refer to their distributions as ‘qualified’ because they come with tax advantages.
To qualify for tax-free and penalty-free withdrawals, the following conditions must be satisfied:
- The first contribution or conversion to your Roth IRA must have occurred five years before the withdrawal.
- You must be at least 59½ years old at the time of the withdrawal.
- You can withdraw up to $10,000 for a first-time home purchase for yourself, your spouse, your children, or your grandchildren. The five-year rule still applies.
Non-qualified retirement plans
Not all retirement plans through employers are qualified. Typically, non-qualified retirement plans are more customized and cater to executives or other key employees.
These include:
- Deferred-compensation plans
- Executive bonus plans
- Split-dollar life insurance plans
Deferred-Compensation Plans
These non-qualified plans allow executives or other handpicked staff to defer part of their salary to a future date, usually until retirement. The deferred amount grows tax-deferred, and when distributions are made, they are taxed as ordinary income. These plans can offer flexibility regarding contribution limits and distribution schedules while helping attract and retain top talent.
Executive Bonus Plans
Also known as Section 162 plans, executive bonus plans involve a company paying for a life insurance policy premium for the employee as a form of extra compensation. The employee pays taxes on the bonus as ordinary income, while the employer can deduct the bonus as a business expense.
Split-Dollar Life Insurance Plans
With this plan, an employer and employee share a permanent life insurance policy’s cost, benefits, and ownership. The premium payments, cash value growth, and death benefits are split between the employer and the employee. These plans can be structured in various ways, but they generally offer tax advantages and help employers provide valuable life insurance benefits to key employees.
Non-qualified accounts
While non-qualified accounts, such as savings and brokerage accounts, do not receive the same tax advantages as qualified accounts, they are more flexible regarding contributions and withdrawals.
For one, there are no limits on how much you can contribute to a non-qualified account, and you can withdraw funds without facing penalties or age restrictions. Also, you only have to pay taxes on any gains you have incurred since you already paid taxes on the original amount.
Qualified vs. Non-Qualified Money in Retirement
While the prospect of putting as much of your retirement funds into a qualified retirement account may sound appealing, striking a balance is a more practical way to ensure retirement stability.
For one, if you don’t have enough money set aside in a non-qualified account, you may be forced to withdraw funds early from your retirement plan, racking up penalties, paying unforeseen taxes, and reducing your account’s ability to produce long-term capital gains.
Even while in retirement, you may want to take advantage of any non-qualified monies you have rather than taking a more significant distribution, as they count as taxable income and may push you up a tax bracket or affect your Medicare premiums.
Also, it’s not as if non-qualified accounts don’t offer their own tax advantages. You can easily take advantage of tax-efficient investments in a brokerage account to reduce your tax burden by using long-term capital gains on things like dividends and growth. Long-term capital gains tax rates are much lower than income rates.
Traditional 401(K)s and other retirement plans distribute taxable income at income tax rates, not capital gains rates, so keep that in mind when choosing what accounts to pull from.
In Conclusion
Knowing if your savings are qualified or not can have huge implications regarding your tax burden, fund accessibility, and safety. By working with a retirement income planner, you can create the ideal proportion of qualified and non-qualified funds for maximum security, stability, flexibility, and tax efficiency.
