In the investment world there are some terms that apply to the investments themselves, and other terms that only apply to the vehicles chosen to hold those investments. The easiest way to understand a qualified retirement plan is to think of it in terms of “qualified for tax benefits.” These rules are set by the IRS and when an account meets the specifications, it is deemed to be qualified. Many people already have a qualified plan without even knowing it. If you have any money in a 401(k), a traditional IRA, or a Roth IRA, you have money invested in qualified retirement plans.
When money is put into most qualified plans, a person will see their taxable income reduced by the amount put into the plan (the exception of course being the Roth IRA, learn more here). Until the money is taken out of the qualified plan it will not be taxed. So a person can buy and sell funds, often at substantial gains, and until they actually withdraw the money they will not be liable to pay any taxes. The downside of these plans is the money is assessed at least a 10% penalty (25% in some instances) if it is withdrawn before the age of 59.5, unless it qualifies for some of the early distribution rules. The reason behind this rule is simply to encourage people to save for their retirement, instead of pulling the money out whenever they feel the urge.
The opposite, a plan that is “non-qualified for tax benefits,” is a plan that does not meet the rules set by the IRS. These accounts are designed for those who earn too much to put money into an individual qualified account, have maxed out their contributions, or they are accumulating money for a big purchase that will happen before they reach retirement age. A non-qualified account can be set up as an individual account, a joint account (with a husband and wife team most often being the joint owners), or an entity account (often a trust, or an estate owning the account). Regardless of who or why the account is set up there are some pros and cons to any non-qualified account.
The biggest downfall to this type of account is that all the realized gains are taxable. This means if a stock or fund is bought at a certain price, all the gains will be “realized” when the stock or fund is sold and those gains are locked in. At this point they are counted as income (if it was held under one year) or long-term capital gains (if it was held over one year) and the investor will receive tax documentation to report the gains the following tax season. All dividends and capital gains are taxed, even if they are reinvested and not taken as cash.
Even though gains are added to a person’s taxes, losses are subtracted from them. If a person has unrealized losses in their account, they can sell their holdings and get a deduction on their taxes. More can be learned about this process here.
Since these accounts are taxed as they go along, the IRS does not assess a penalty if the money is taken out before age 59 ½. At any point a person can add to, or withdraw from the account. There is no limit set on contributions or distributions.
Finding the right investment account is important for anyone who wants to store money for the long run. A non-qualified account might hit them with a tax burden before they want it, and a qualified account may tie up their money for too long before they need it. However, most people who are just getting started investing can benefit from the forced discipline a qualified account will offer. In the next article we will explore the various types of qualified retirement plans and what they can do for those planning their retirement.