One of the most important distinctions in estate planning is whether one’s assets are “qualified” or “non-qualified.” The distinction comes from their treatment by the IRS. Qualified assets are those that qualify for special tax treatment. Specifically, the IRS allows individuals to put money in an investment account and either deduct the amount from their taxes or, in the case of an employer sponsored retirement plan like a 401(k) or 403(b), transfer the money to the account before any taxes are paid. Money set aside in these qualified accounts then grows free of any interest, dividend or capital gains taxes. It is only when the money is withdrawn that taxes are paid. In the case of a qualified account, the amount withdrawn is taxed as ordinary income. For the most part, it is taxed the same as your wages or salary. Since the United States uses a progressive tax code, the amount of tax you pay on qualified withdrawals depends on your overall income. The higher your income, the higher the marginal tax rate you will pay. Another feature of qualified accounts is that the government requires that you begin to withdraw money from a qualified account when you reach the age of 70½. This requirement, called an RMD or Required Minimum Distribution insures that the government eventually will collect the taxes that have been deferred during the time of accumulation. In addition to the 401(k), 403(b) and IRA, there are other qualified accounts such as a 457, SEP IRA, and Simple IRA.
Non-qualified accounts are those that do not qualify for special tax treatment by the IRS. They are registered either as a single brokerage account, individual brokerage, joint brokerage or trust.
The money in a non-qualified account has already been taxed. Because it’s after-tax money, no income tax has to be paid when it is withdrawn. However, any interest, dividends or capital gains that the account generates are subject to a tax on a yearly basis.
Then there is the Roth IRA. The Roth IRA can be a qualified account that combines the best features of both qualified and non-qualified accounts. Only after-tax money can go into a Roth IRA. Since the money in a Roth has already been taxed, you don’t pay income taxes when it is withdrawn. But in addition, you also don’t pay any interest, dividend or capital gains taxes while the money grows.
For estate planning purposes, the importance of the qualified accounts is that they pass by beneficiary designation. All qualified accounts are given out according to beneficiary designation forms that you fill out when you open the account. These forms can also be amended at any time if you want to update or change a beneficiary. It is critical to keep the beneficiary forms updated. For instance, in most cases, a married couple will name the spouse as the primary beneficiary, and include contingent heirs if the surviving spouse passes before the assets are distributed. Contingent beneficiaries are vital for your account.
Understanding both the impact of qualified and nonqualified money on your estate and the importance of beneficiary designations on qualified money is the first step toward building retirement accounts that last throughout your whole life.
We are launching a series covering qualified and unqualified money and this distinction’s effect on your retirement accounts. Look for our next post on how qualified money affects each stage of your retirement.