One of the common questions we hear is, “what’s the difference between qualified and non-qualified money or accounts”?

The investment community is a loud and confusing place for the savvy, experienced investor, let alone for someone who’s trying to figure out what’s right for their family.  The lingo tossed around by financial pros  to “simplify” the situation often doesn’t help the situation either.  One of the most common questions you may ask is the difference between Qualified (Tax Deferred) accounts, and Non Qualified (Taxable) accounts, and the role that each should play in your financial plan.  These are important questions, so let’s unpack the question so you better understand how your accounts can work together in tandem to better serve your overall financial   objectives.

Qualified investments are most commonly your employer sponsored retirement plans such as  401(k) plans, 403(b) plans, and 457(b) plans.  If you’re self-employed your Qualified Plans could also include your SEP or SIMPLE IRA, a SOLO 401(k), defined benefit plan, etc.  If you’ve left a previous employer, you might also have a traditional IRA.  There are two primary benefits to Qualified plans that incentivize people to participate.

First, you’re contributions to your Qualified retirement plan are deducted from your taxable income in the year that you make the contribution.

Second, all of the growth earned in the account continues to grow in a tax-deferred status until you actually take money out of the account in the future.  This offers compounded growth on your investment, which over the course of time can offer significant additional growth potential in your account.  In most cases when you withdrawal the money you’ll pay regular income tax on that amount.

There are also important considerations that you must be aware to get these benefits.

First you trade accessibility and flexibility for tax-deferred growth in these accounts.  They’re considered retirement accounts for a reason.  They’re intended to serve you in your retirement, and the government has attached significant restrictions and penalty to these accounts to ensure you don’t touch them before you retire.  In fact, if you need to take money out of your retirement account before you reach the age of 59 ½, the government may penalize you to the tune of an additional 10% penalty (on top of regular income tax) for taking an early withdrawal.  That 10% penalty will apply to any money taken out of the plan that gets included in your gross income.  There are a handful of ways to avoid the additional penalty, which are provided in the IRS code.  You can check those details out at the following link.

If you’re considering taking early withdrawals from your retirement plan, be sure to consult with a professional who has understanding of the rules and how to help you construct a distribution plan that may avoid unnecessary penalty.

The second issue that you have to keep in mind is that the IRS doesn’t just restrict how early you can take withdrawals from your plan, they also restrict how long you can wait to start taking money out of the plan.  You have to begin taking money out of your plan no later than age 70 ½.  They call this requirement your Required Minimum Distribution, and they’re even kind enough to tell you exactly how much you have to take.  In the event that you miss the requirement and don’t take money out in time, or don’t take out enough to satisfy the requirement, you’ll also face the stiff penalty of 50% imposed on the amount that you were supposed to take out and didn’t, plus you still owe income taxes on the distribution as well.  So the reality of your plan is that you have an 11 year window where you have any real control over whether you take money out of your account or not, without IRS restriction (from the time you hit 59 ½ till 70 ½).

This brings us to consideration # 3, and in my opinion, probably the most important.  The future tax implications of your Qualified plans.  Tax-deferral means that you’re simply postponing the tax you’re paying on your accounts.  Not only do you postpone the tax paid, but you also postpone the tax calculation.  The tax that you pay will be based on your tax rate at the time of distribution.  Conventional financial guidance typically tells you that you’re likely to experience a lower tax bracket in retirement.  We question the likelihood of that though.  First, from a lifestyle standpoint, do you think you’ll want to take a pay cut in retirement?  Think of your typical Saturday today.  What does that look like?  Recreational activities?  Maybe some golf?  Some shopping?  A meal or two out?  Well guess what…in retirement, EVERY DAY IS SATURDAY!  Will you really spend less?  Particularly early in your retirement?  It’s worth questioning…

Couple that with the fact while you’re working today, you have the most tax deductions that you’ll likely ever have.  You’re probably still paying on your mortgage?  Maybe you have kids still at home?  Charitable contributions?

What about in retirement?  Your house is likely paid off, your kids are out of the house, and you still donate to charities, but now you donate your time, not your money.  Unfortunately the IRS places a value of exactly zero dollars on your time…sorry to be the bearer of bad news.  We haven’t even touched the subject of our tax system today, and how brackets could potentially change in the future. Based on what you know about the US debt and future obligations (Medicare and Social Security specifically), do you think taxes are likely to be higher or lower in the future?  Again, no one has a crystal ball, but we can make informed guesses.  So with all that in mind, will you really be in a lower tax bracket in retirement?  Not so sure…

Now, moving on to Non-qualified investments.  Non-qualified investments are accounts that do not receive preferential tax treatment. No deductions for the money you contribute to them, and no deferral on the growth you earn.  What you give up in tax benefit, you make up for in additional liquidity (accessibility) and flexibility.  There’s no restriction on how much or how little you decide to invest, and no limitation on how much or how little you take out, or when you take it out.  The money that you use to invest in non-qualified investments is the money that shows up from your paycheck and ends up in your bank account, so you’ve already paid tax on it.  Theses dollars that get reinvested establish something called your “cost basis”.  This is simply the money recognized by your investment company as dollars that have already been taxed, to make sure you aren’t  taxed on them again.  When you  take money out of these accounts, you’re be taxed on the growth in the account, but not on your cost basis.

So which is better?  How do you know how much to put in one account vs the other?  It really boils down to your personal philosophy and priorities.  The first and most important question that you may want to ask is whether you believe your taxes will be higher or lower in the future.  If you think that they’ll be higher, you may be better served to pay the tax man sooner rather than later, because technically you’re getting taxes “on sale” if that’s your belief.  If, on the other hand, you’re of the opinion that your tax rate will be lower in the future, you should take advantage of the preferential tax treatment offered by Qualified accounts, and sock as much money as you can afford into your retirement plans.

The other factor that you have to weigh is how much access you need to your accounts.  If you’re concerned about the limited level of liquidity afforded through Qualified accounts, you’ll want to make sure that you’re saving enough in Non-qualified accounts to deliver the level of access to your money that you need to feel comfortable.

Finally there’s a third kind of account that factors into the equation.  Tax-exempt accounts.  These are accounts that offer distributions that are free from future taxation.  Examples of these kinds of accounts are Roth 401(k)s and Roth IRA’s, as well as Health Savings Accounts.  There are also provisions in the tax code that exempts certain permanent cash value life insurance from being taxed.  These accounts can be particularly valuable if you think taxes might be higher in the future, because they can take the risk and uncertainty off the table..

At the end of the day, a properly constructed financial plan should really include all the above; Qualified (tax-deferred), Non-qualified (taxable), and Tax-exempt (tax-free) accounts.   The beauty is, with the proper balance, you can strategically position your accounts to achieve “tax-diversification”, which can dramatically reduce, and in some cases, even eliminate taxes from your retirement plan, offering the opportunity to receive significantly more take home income for you in the future.

Be sure to consult with a financial professional who can guide you through a process to help you determine what makes sense for you and your family.