Many people who save for retirement have access to qualified plan accounts such as 401(k)s. Yet you don't have to do all of your saving in a qualified account, and many people use regular nonqualified investment accounts to supplement their retirement savings. Below, we'll take a look at the difference between these two types of accounts to help you decide which is right for you.
What's a qualified plan account?
Qualified plans refer to employer-sponsored retirement plans that comply with the requirements of the tax laws, as well as a law called the Employee Retirement Income Security Act of 1974, or ERISA for short. ERISA-qualified accounts offer tax benefits, including tax deferral of income within the account, tax deductions or exclusions for contributions to a traditional qualified account, and the right to roll over fund balances into an IRA. By contrast, nonqualified plans don't comply with those provisions and therefore aren't treated the same way for tax purposes.
Technically, IRAs aren't qualified plans, because they aren't offered by employers. Nevertheless, in considering the tax consequences, it makes sense to treat them in the same way as qualified plan accounts, because the tax deferral and deduction features are similar.
How qualified accounts are useful
There are many advantages to qualified accounts. On the investing side, being able to earn income without paying taxes until you make a withdrawal has huge long-term advantages, boosting your ability to build up your retirement nest egg. Deducting contributions can give you a big upfront tax break as well.
Another advantage of qualified accounts is that ERISA provides some protection against creditors. Both ERISA-qualified plan accounts and IRAs are entitled to preferential treatment in bankruptcy proceedings, and different states have different rules on how to handle qualified plan accounts and IRAs for state-law purposes and for creditor proceedings not involving federal bankruptcy law.
The downside of qualified accounts is that they generally penalize you for taking money out before you reach a specified age, typically 59-1/2. Therefore, if you need money prior to reaching that age, a regular nonqualified investment account is useful.
For the typical retirement saver, having a mix of qualified and nonqualified accounts is best to provide balance and flexibility. That way, you know you can always access some of your money while also taking advantage of tax benefits for the rest.
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