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Qualified vs. Non Qualified

Original research and information derived from the Internal Revenue Service and the New York State Insurance Department.

Qualified accumulations are certain types of savings and investment vehicles that qualify for special federal tax treatment of:

  • Money that is contributed to the plan and
  • Accumulating funds that are composed of contributions plus earnings on the contributions.

Most nonqualified accumulations, on the other hand, are placed in savings or investment vehicles that receive no special tax treatment. (Deferred annuities are an exeption: they enjoy tax-deferred accumulation even through "nonqualified.") Both types of accumulations are intended to amass retirement income that will be withdrawn in the future.

Qualified accumulations can result from:

  • Employer-sponsored retirement plans established for the benefit of employees, or
  • Individual Retirement Accounts (IRAs) established by individuals on their own behalf.

Qualified employer retirement plans that meet tax code requirements provide a tax deduction for contributions the employer makes on behalf of employees. The employer may deduct from its income taxes contributions made to the qualified plan.

Employees benefit from a qualified employer-sponsored plan in several ways:

  • Contributions are made with pre-tax dollars (with a few exceptions), which means the amount of the contribution is not included in the employee's gross income.
  • With arrangements such as a 401(k) or 403(b) plan, where employees contribute a portion of their earnings, employers frequently match the contributions up to a certain percentage of the employee's income, further increasing the amount of the accumulations.
  • Ongoing contributions and the earnings on accumulations in the qualified plan grow on a tax-deferred basis-no taxes are generally due until funds in the plan are withdrawn.

Individual Retirement Accounts (IRAs) may also be treated as qualified arrangements within fairly stringent limits. Individual wage earners who are not covered under an employer plan may make annual tax-deductible contributions for themselves and for an unemployed spouse, as long as they meet all of the federal requirements regarding income and age. The maximum amounts that may be contributed and deducted each year are stipulated by law and subject to change.

Certain wage earners who are covered by an employer plan may also make deductible contributions if their incomes fall below certain thresholds that change annually. Above a certain level of income, however, individuals are no longer eligible to take the tax deduction for IRA contributions. These individuals may still contribute to the IRA with after-tax dollars. In all cases, the accumulations grow on a tax-deferred basis.

As a result of tax law changes in 2001, people 50 and older may make "catch-up" contributions that exceed the regular IRA contribution limits.

To summarize, IRA contributions are:

  • Tax-deductible within limits and contribution maximums specified in the tax code.
  • Permitted on an after-tax (nondeductible) basis when the individual does not qualify for the tax deduction.
  • Allowed to accumulate on a tax-deferred basis until withdrawn.

Contributions to savings and investment plans that do not qualify for tax benefits are called nonqualified accumulations. Contributions are made with after-tax dollars; there is no tax deduction. However, when such funds are withdrawn, the principal amount that was invested is not taxed; only the earnings portion of the withdrawal is taxed.

Earnings in a nonqualified arrangement may be taxed currently, rather than tax-deferred, depending on the particular type of savings or investment vehicle. For example:

  • Interest paid on a bank savings account or certificate of deposit is taxed as current income in the year it is received.
  • Interest paid on most investments is taxed as ordinary income, but interest on certain investments, such as municipal bonds, may be tax-exempt.
  • Dividends received on stock and most mutual fund investments is generally taxed as ordinary income. (There is currently talk in Washington of allowing a partial exclusion for dividend income.)
  • Interest paid on the cash accumulation in an annuity contract generally is not taxed as long as it is left to accumulate. Tax is deferred until the owner begins receiving periodic income payments, and earnings are taxed at that time.

To see the significant difference in results between qualified and nonqualified accumulations, look at this example of how early taxation and using after-tax dollars reduces the accumulation, as compared to deferred taxation and using pre-tax dollars.

A 40-year-old puts $3,600 annually into a nonqualified vehicle that earns 8% before taxes. In this nonqualified arrangement, the effective interest rate is only 5.75% after accounting for the taxes already paid on the $3,600. After 25 years, at the individual's age 65, the accumulations that result from using after-tax dollars total $148,584.

Another 40-year-old puts $3,600 annually into a qualified plan that earns 8%. These pre-tax contributions grow on a tax-deferred basis during the 25-year accumulation period. Under this qualified plan, at the individual's age 65, the total accumulations are $297,822-$149,238 more than the nonqualified plan.

It's easy to see that tax deferral has an enormous impact on the amount of cash accumulated over the long term.

While life insurance and annuity contracts are not considered to be qualified plans (except in the case of an annuity used to fund an IRA), the accumulations in these contracts receive favorable tax treatment.

The premiums paid for life insurance and annuity contracts are not tax-deductible, but the earnings for both accumulate on a tax-deferred basis until withdrawn. At that time, taxes are due only on the earnings portion of the withdrawal.

It is important to consider the tax consequences of savings and investment options before deciding how to accumulate retirement income. Some important questions include:

  • Are contributions made with pre-tax or after-tax dollars?
  • Are earnings taxed during the time they are accumulated, or are taxes deferred?
  • When accumulations are withdrawn, are they fully or partially taxed, or not taxed at all?

Figures, calculations, and illustrations are for illustrative purposes only. They are based on hypothetical rates of return and do not represent investment in any specific product. They may not be used to predict or project investment performance. Unless noted, charges and expenses that would be associated with an actual investment are not reflected.

Economic Evaluation Group, Inc. has Licensed Brokers and Licensed Financial Planners to help with your questions.  Please Contact Us with any questions regarding this or any other insurance or financial service.  Be sure to also join our informative newsletter and be included in information-packed emails.

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