Non-Qualified and Traditional IRAs

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Traditional Individual Retirement Accounts and non-qualified retirement accounts are both considered to be retirement accounts by the Internal Revenue Service and are sheltered from taxation. The specific rules and details of how the account shelters retirement savings from tax differs for each account, however. Make sure you understand how these accounts work before you invest in them.

Types

Non-qualified retirement accounts primarily refer to annuity policies. An annuity is an insurance contract that pays a guaranteed income payment during retirement. The money builds up as a savings prior to retirement and is invested in a fixed interest account or in mutual funds. The retirement income can be deferred for as long as you want, up to and including until your death. Traditional IRAs are sanctioned by the IRS. Money is contributed to the account and invested in a variety of investments from stocks, bonds, mutual funds, real estate and precious metals.

Significance

The significance of a non-qualified retirement account is that there are no contribution limits. You may contribute as much money as you want to the account. However, all contributions are after-tax and all gains in the contract are taxed when you make distributions from the account. Traditional IRA accounts accept pretax contributions and withdrawals are taxed at ordinary income tax rates.

Benefit

The benefit of a non-qualified retirement account is that you aren't discouraged from saving money. Because there are no contribution limits, you may save as much money as you can afford to save. These plans also ensure that you'll never run out of money during retirement if you elect the guaranteed income option after age 59 1/2. The benefit of a traditional IRA is that you are able to invest pretax dollars toward your retirement. This may result in a larger pre-tax retirement savings than with a non-qualified plan.

Disadvantage

The disadvantage to a non-qualified plan is that the plan may produce less income overall than a traditional IRA since contributions and gains are taxed. The tax benefits are much more limited than with a traditional IRA. The disadvantage to a traditional IRA is that you must take distributions from the IRA after age 70 1/2. The distribution is called a required minimum distribution and must be made according to Table III of the IRS' life expectancy tables in the appendix of publication 590. If you don't, then you will be assessed a penalty. The penalty is 50 percent of the amount of money you should have withdrawn but did not.

Considerations

Before contributing to either retirement plan, consider what your retirement goals are. If you want to make unlimited contributions to your retirement account, then a non-qualified plan may be best. If you want more tax benefits than a non-qualified plan offers, consider a traditional plan. Alternatively, consider a Roth IRA plan. Money is deposited into a Roth on an after-tax basis and withdrawals are not taxed at all during retirement.

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References

  • IRS: Publication 590
  • "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
  • "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
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