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 This has turned out to be a bit of a trap, in that $1.30 to $1.50 may be needed for every $1 withdrawn.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 The IRA owner not only pays taxes on the withdrawal, but taxes on the part withdrawn to pay the taxes!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 That is because assets invested after 5 years and age 59 ½ may be withdrawn tax free.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

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