When looking at finances or retirement planning, it is almost impossible to not come across the terms “qualified” and “nonqualified”. Many times, we have clients asking us what these terms mean and how they apply to their money. 

Most everyone has qualified and non-qualified money, especially if you are near or in retirement.  

It is essential that you have a basic understanding of what these terms mean.

Understanding Qualified Money

Qualified money basically refers to money in retirement accounts, such as IRAs, 401(k)s, and 403(b)s. 

ERISA, or the Employee Retirement Income Security Act, invented qualified money. Before 1974, the only retirement accounts that existed were really just pensions. 

ERISA created IRAs, 401(k)s, and other retirement accounts. With this, they also created the rules that “qualify” the money in these accounts, which is where the term qualified money, or qualified accounts, came from.  

Qualified accounts get tax advantages that non-qualified money does not receive. The big advantage is that you get to use pre-taxed money to fund these accounts. 

You also do not have to pay taxes on the gains in these accounts until you start withdrawing the money. 

With the advantages that qualified money received, there are many rules and regulations that surround it.

For example, the IRS limits on how much money you can put in these qualified accounts annually. In 2020, the annual contribution limit for an IRA is $6,000. If you are over 50, it rises to $7,000. Other types of qualified retirement accounts have different limits. 

You also cannot withdraw money from these qualified retirement accounts until you are 59 ½ . If you do make a  withdrawal, not only do you have to pay taxes on the money, but you also incur a 10% penalty charge. 

There are also rules about leaving money in qualified accounts for too long. For example, with Traditional IRAs and 401(k)s, you must start taking RMDs, or required minimum distributions, at the age of 72. If you do not, you will incur a hefty 50% penalty. 

The IRS also limits the types of investments you can hold in qualified accounts. For example, these accounts cannot hold investments such as collectables or life insurance. 

There are many more rules, specific to each type of account, but these are the ones most people are going to run into. 

You need to be very careful putting money into qualified accounts as well as withdrawing money. Mistakes with qualified money can cause the whole account to be taxable. 

Understanding Non-Qualified Money

Non-qualified money is money that you have already paid the taxes on.

For this reason, non-qualified accounts, such as a savings account or a brokerage account, do not receive preferential tax treatment. 

For this reason, this money has less rules and regulations than qualified money. You can put in as much or as little money as you want. You can also withdraw non-qualified money at any time. 

When you withdraw non-qualified money, you only have to pay tax on the gains since you already paid taxes on the money you put into this account. 

Understanding qualified vs. non-qualified money in retirement 

Before retirement, most people are just putting money into qualified and non-qualified accounts and leaving it there. When in retirement, it is essential you understand how the money in these accounts can be used since you are going to be living off of it. 

At Cardinal, we see many retirees with the bulk of their savings in qualified accounts. All of their money is in their IRA or 401(k).

While these are great retirement savings vehicles, there are instances where it can put you at a disadvantage to have all your money in these qualified accounts. 

For example, say you are in retirement and want to do a home renovation project. This project is going to cost $50,000. 

While you know you have enough money in your IRA to cover it, what many people don’t realize is they actually need to withdraw a good amount more than $50,000 in order to net the $50,000 needed for the revocation. 

This is due to the fact that you are going to have to pay taxes on all $50,000 withdrawn. 

Withdrawing this extra $50,000 is also going to raise your income for the year, which can affect everything from the taxes you pay on your Social Security benefit to the amount you pay for Medicare. 

This is why we make sure most of our clients at Cardinal have some money in non-qualified accounts that they can use for major expenses without dramatically increasing their income and inadvertently increasing their costs for other things. 

Cardinal can help you understand qualified and non-qualified money, and how to make sure you have the right amount of both for your retirement.