Like it or not, the IRS is most definitely a stakeholder in your retirement planning. That’s because many of your accounts come with highly-attractive tax benefits. As you probably already know, the government never gives anyone anything that doesn’t have a long string attached and multiple hoops to jump through.
In a regular investment account, you pay taxes on your contributions. You also pay taxes annually on your investment gains.
Suppose you sold 200 shares of stock and made $2,500 on the sale. You will pay taxes on the $2,500. The same applies to dividends you get or any other type of capital gain.
Retirement accounts work differently. If you hold certain retirement accounts, you don’t pay taxes on gains until you withdraw those funds.
Qualified plans vs. Non-qualified plans: What’s the difference?
What is a qualified plan?
If you are like millions of Americans with a 401k, you own what’s known as a “qualified plan.” These retirement accounts fall under a set of laws in the Employee Retirement Income Security Act (ERISA).
For employers, qualified plans are attractive because of the tax deductions companies receive for contributions they make on behalf of their employees. Your company, for example, may contribute a percentage of your income to your 401k as part of your benefits package.
If your plan is a non-Roth 401k or an IRA, the company deposits contributions to that account without taking out any taxes.
This situation is known as a “pre-tax contribution,” and you won’t pay taxes on gains until you make withdrawals later. Your money is growing tax-deferred.
However, one of the limitations of qualified plans is that employees are limited in the amount they can contribute annually. In 2022, the cap for 401ks is $20,500 a year. Other qualified accounts have different maximums, and some have additional benefits for people closer to retirement.
It’s vital to remember that you can’t take penalty-free withdrawals (except in limited circumstances) until you are at least age 59½. Those penalties, by the way, are hefty and can take a significant bite out of your wealth.
Another thing of which you should be aware is that most plans have what are known as “required minimum distributions,” or RMDs. RMDs kick in when you reach 70½ or 72, depending on your date of birth. You must start taking withdrawals at that time, even if you don’t need them.
What is a non-qualified plan?
Unlike qualified plans, non-qualified investment accounts do not receive preferential tax treatment. They are also not subject to many limitations of qualified plans. With a non-qualified plan, there is no minimum or maximum amount you must invest, and you can withdraw money at any time. Sometimes, non-qualified plans are offered to senior management or other highly-compensated employees as perks to offset these employees’ lower maximum contribution limits to their company plan.
The IRS considers money invested in a non-qualified account to be the cost basis of that account. When you withdraw the cost basis, you are not taxed again on that money since you already paid taxes on it.
Should I have both qualified and non-qualified accounts?
Depending on where you are in your financial life, a case could be made for having both qualified and non-qualified retirement accounts in your portfolio. Many advisors suggest that if having more options and greater flexibility is essential to you, a balance of qualified and non-qualified investment accounts makes good sense. Now may be the perfect time to ask your retirement and income specialist for a portfolio review. You and your advisor can determine if your current investment mix needs rebalancing to better align with your current situation and risk tolerance.