Tax-deferred investments, like qualified retirement plans, offer long-term benefits by letting you generate returns on pre-tax income. However, restrictions on investments in such qualified assets limit how you can use them, which means they may not be suitable for meeting some of your financial goals. If, for example, you want to withdraw funds from a qualified plan for a major home improvement project, you will have to take out more than you need so that you can cover taxes as well as the building costs. However, you could fund that same project with fewer proceeds withdrawn from nonqualified assets, which provide more flexibility in exchange for a less-favorable tax status.
Qualified vs. Unqualified
Though you may be limited in how much you can contribute in a given year, a qualified asset, like a 401(k) retirement plan, allows you to make pre-tax deposits, and you don’t have to pay taxes on your contributions or earnings until you withdraw funds. You can delay taxes until after you turn 70 ½ years old, at which point you must start withdrawing funds under required minimum distributions provisions. In order to have a retirement plan qualified, employers must meet certain criteria, like providing plan documents to participants upon request, covering a specified minimum amount of employees and avoiding discrimination by distributing benefits fairly. Nonqualified retirement plans that do not offer any level of tax-deferred or tax-exempt status do not have to meet such criteria.
Flexibility of Nonqualified Assets
Though you make contributions after paying taxes, you usually are not limited in how much you can invest annually in nonqualified assets. You also can likely withdraw funds sooner, and you may be able to do so as often as you want, though some nonqualifying investment accounts may penalize you for early withdrawals, like before you are 59 ½ years old.
You only pay taxes on the gains you earn on a nonqualified asset. You are not taxed when you withdraw your initial investment, which is considered to be your cost basis, because you paid taxes on that income before you invested it in the asset. Your returns are taxed annually. Your taxes may be reduced in some cases, like if a predetermined annuity payout that you receive includes some of your initial investment, which again had already been taxed.
Examples of Nonqualified Assets
Annuities are one example of a nonqualified investment. Other examples include art, jewelry and antiques. Stocks, bonds and other types of investments made outside of qualified plans or trusts also may be considered to be nonqualified assets.
Jim Molis has written about money management and financial services extensively during more than 20 years of experience as an editor and writer. He has been a staff writer for The Bond Buyer and a banking and finance reporter for the Atlanta Business Chronicle. He also has written for accountants and wealth advisors and has contributed to numerous publications as a freelancer.