Savings options

Qualified vs. Non-Qualified: Not All Savings are Equal

by Kristina K. Bolhouse, CPA/PFS, CFP®

Two of the most confusing terms in personal finance are “qualified” and “non-qualified” savings. We are sure there are better terms that could be used, but in this case, we can blame the United States tax code. It is important to understand the difference, so here is the distinction:

Qualified Savings

The term “qualified” refers to a plan that receives preferential treatment under the IRS Code. The most common accounts are Individual Retirement Accounts (IRAs), 401ks, Roth accounts, and various other tax deferred savings accounts. To be qualified, certain rules must be followed. For example, in general, an IRA cannot be accessed without penalty before age 59 & ½. Such a plan also “qualifies” for tax deferred growth. This means you don’t pay the taxes each year, but instead when you take the funds out of the plan.

Non-Qualified Savings

The term “non-qualified” refers to any asset that is not part of a qualified plan. For example, your bank account is a non-qualified asset. You may also have an investment account outside of your retirement plan. That is also considered to be “non-qualified”. For non-qualified investments, the taxes on the income or realized gains each calendar year are reportable on your income tax return. The benefit of a non-qualified account generally lies with control: the account owner has control, and for the most part can take funds in and out at will. There may be other restrictions, such as on a bank CD, where penalties are assessed for early withdrawal. However, on the whole, these funds are much more readily accessible than qualified assets.

Which is Better?

We have observed that some retirees have 100% of their retirement assets in qualified plans (401k, IRA, etc.). That means that for every dollar that they need in retirement from their qualified account, income is reported on their tax return. This has turned out to be a bit of a trap, in that $1.30 to $1.50 may be needed for every $1 withdrawn. For example, a $10,000 new roof may require a $15,000 IRA withdrawal. The IRA owner not only pays taxes on the withdrawal, but taxes on the part withdrawn to pay the taxes!

For our clients, we’ve observed the ideal situation in retirement is to have 25% or more in non-qualified assets. Roth assets are the next best thing to non-qualified. That is because assets invested after 5 years and age 59 ½ may be withdrawn tax free. However, because of the tax free growth benefit, retirees always want to use those assets last, to attain the greatest amount of tax-free benefit.

As you can see, it can be tricky trying to determine the best type of savings. We’ve observed the best mix is to have both types, but especially Roth assets, if at all possible. The benefit of this is that in retirement, the taxpayer can have a much better ability to choose the timing and extent of taxes based on the nature of how it is taxed and characterized.

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by The Arkansas Financial Group, Inc.-“AFG”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from AFG. Please remember that if you are a AFG client, it remains your responsibility to advise AFG, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. AFG is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the AFG’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request. Please Note: AFG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to AFG’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Leave a Comment