What makes an account
Qualified? Tax benefits
You harvest this year.

One of the most common words you’ll encounter in finance is “Qualified.” Accounts can be Qualified, businesses and charities can be Qualified, transactions can be Qualified, even sections of the United States can be Qualified.

But what makes something Qualified vs. Non-Qualified? Tax benefits.

Some examples:

A Traditional IRA is a Qualified Account. So is a 401(k), or a 403(b). SIMPLE and SEP IRAs are Qualified as well. What do all of these accounts have in common? They give taxpayers the ability to defer income this year so that they can pay taxes on that income at a later date, provided they follow the rules.

But after-tax dollars go into Roth IRAs. Since taxes have already been paid, there is no current year tax benefit to contributing to a Roth IRA. This makes the Qualified status of Roth IRAs somewhat fuzzy. Some say that Roth IRA accounts aren’t Qualified, but are their own category entirely.

Yet Roth IRAs pop up as Qualified Accounts on custodian paperwork (think Charles Schwab, Fidelity, Vanguard, every insurance carrier I’ve encountered, etc). These huge firms aren’t splitting hairs. As far as they’re concerned, Roth IRAs are Qualified.

As soon as dollars go into a Roth IRA, they may start generating dividends and/or interest. These would normally be taxable events, but not inside of a Roth IRA. Like their Traditional siblings, Roth accounts grow tax deferred. Contributions may not get a deduction, but tax deferred growth is an evergreen tax benefit for every dollar in the account.

You can think of Qualified Accounts as your best friend’s house. You like to visit. The house is nice. Your friend is a good hang.

But your friend’s parents are mean. The rules are strict and there’s a steep cost of breaking them. You suspect that your friend’s folks don’t even like you.

Just like your best friend’s house, there are lines you’re not allowed to cross in a Qualified account. Just because you have money in a Qualified Account doesn’t mean you are going to get all of the tax benefits that account provides.

There are always rules to follow inside Qualified Accounts, and the penalty for breaking the rules of the tax code can be steep. Not only will you have to pay taxes on any tax-deferred growth inside of an account with appreciated value, but you will also have to pay a penalty to the IRS. You can visit your best friend’s house (Qualified Accounts and the tax benefits therein), but you have to follow the parent(IRS)’s rules.

For example, someone withdrawing money from an IRA before the age of 59 ½ will trigger a 10% penalty in addition to ordinary income taxes and potentially state taxes on the IRA distribution. Such a withdrawal would be considered a Non-Qualified Transaction.

A similar mistake in a Health Savings Account (withdrawing funds before age 65 without using them to reimburse medical expenses) will trigger a 20% penalty.

If you miss a Required Minimum Distribution (the rules for which just changed as of January 1, 2023), you will pay a 25% penalty (reduced to 10% if you correct the mistake in a timely fashion).

In the case of a Traditional IRA, if an under 59 ½ account owner wants to make a Qualified Transaction, it would need to be through a Rollover, either into a Traditional IRA or a Tax-Deferred Employer Plan (like a 401(k)) that accepts such rollovers.

Rollovers allow the account owner – as long as they follow the rules - to move funds from one Qualified Account into another, similarly Qualified Account and pay no taxes or penalties in the process. Exceptions exist everywhere, and rollovers are no exception.

A Roth Conversion rolls money from a Traditional IRA into a Roth IRA. The tax qualifications of these accounts don’t match: the IRA may hold deductible contributions, the Roth IRA does not. A Roth Conversion rolls funds from an IRA to a Roth so that it avoids the 10% penalty on an under-age-59 ½ transaction out of the Traditional IRA. But the account owner must still pay ordinary income taxes on the rollover.

At the end of the day, like gravity, there’s no way to completely escape taxes. I generally think of the tax code as the sun in the center of our financial solar system. Perhaps a black hole is a better analogy.

Once in the event horizon of the black hole, there is no known way to escape its gravity. If you’re participating in the economy, there is no way to completely escape taxes.

Money that goes into Qualified Accounts must eventually come out, and when it does it will be exposed to taxes as ordinary income. Of course, if you donate money through a Qualified Charitable Distribution to a Qualified Charitable Organization that meets the QCD rules, the funds will not be taxable income either to the account owner or the charity.

Traditional IRAs and Employer Plans get the benefit of a tax deduction when funds go into the account, and tax-deferred growth while funds stay in the account. But when money comes out of the account, you will pay the taxes you legally avoided when the money went in.

Roth IRAs have a huge advantage in this department. Appreciated funds can come out tax-free. But when they do, where do they usually go first? Checking and savings accounts, where they start generating taxable interest (albeit in usually tiny amounts). Eventually the money gets spent on products and services that probably carry sales tax.

So, much like weed seeds blowing into a garden, at some point there’s a need to simply accept that taxes are part of the landscape. And just like weeds they have to be managed so as not to strangle good fruit.

Following the rules that make accounts, transactions, and strategies Qualified - and knowing when and why to use them - may help make your financial garden produce a healthy harvest.

If you want help understanding how, why, and when to use Qualified Accounts in your portfolio, we would love to hear from you.