Investment That Doesn't Qualify: Meaning, Samples, Tax Implications
Understanding Non-Qualifying Investments: Taxable Now, Not Later
When it comes to investments, understanding the tax implications is crucial. One category of investments that requires special attention is the non-qualifying variety. These investments do not offer any tax-deferred or tax-exempt status, meaning the income and gains they generate are generally taxable in the year received.
Annuities are a common example of non-qualifying investments. Unlike their qualified counterparts, withdrawals from non-qualified annuities are taxed on the interest and other gains that have accrued. However, the cost basis (the originally invested money) in non-qualified annuities is not taxed again because those taxes were already paid.
Non-qualifying investment accounts may require mandatory withdrawals at a certain age, usually 73. But the good news is, account holders can make withdrawals from non-qualifying investments at their discretion.
Examples of non-qualifying investments that do not usually qualify for tax-exempt status include REITs (Real Estate Investment Trusts) and REIT funds, junk bonds (High-Yield Corporate Bonds), high-dividend stocks that pay nonqualified dividends, and assets like antiques, collectibles, jewelry, precious metals, and art.
REITs and REIT funds, for instance, have their dividends typically counted as nonqualified dividends, taxed at ordinary income tax rates rather than at lower qualified dividend rates, making them less tax-efficient in taxable accounts. Junk bonds pay interest that is generally taxable as ordinary income and not tax-deferred or exempt. High-dividend stocks with nonqualified dividends also fall under this category, with dividends on stocks held less than 60 days and on certain high-dividend stocks taxed as ordinary income without preferential tax treatment.
These types of investments are often better held within tax-advantaged accounts (IRAs, 401(k)s, Roth IRAs, etc.) because their distributions generate taxable income that would otherwise be taxed immediately in a taxable account.
On the other hand, tax-exempt investments include municipal bonds and tax-exempt mutual funds holding government securities that generate federally tax-exempt interest income.
It's important to note that early withdrawal from certain types of non-qualifying assets may incur penalties, typically before age 59½. As with any investment decision, it's always wise to consult with a financial advisor to ensure you're making the best choices for your financial future.
[1] Investopedia. (n.d.). Nonqualified Investments. Retrieved April 15, 2023, from https://www.investopedia.com/terms/n/nonqualifiedinvestments.asp [2] IRS. (n.d.). Individual Retirement Accounts (IRAs). Retrieved April 15, 2023, from https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras [3] Investopedia. (n.d.). Tax-Exempt Securities. Retrieved April 15, 2023, from https://www.investopedia.com/terms/t/taxexemptsecurities.asp [4] IRS. (n.d.). Publication 550 - Investment Income and Expenses. Retrieved April 15, 2023, from https://www.irs.gov/publications/p550 [5] IRS. (n.d.). Publication 925 - Passive Activity and At-Risk Rules. Retrieved April 15, 2023, from https://www.irs.gov/publications/p925
In the realm of non-qualifying investments, tokens from Initial Coin Offerings (ICOs) can be considered, as they generally do not offer tax-deferred or tax-exempt status, meaning any gains or income from these investments are typically taxable in the year received. Conversely, personal-finance strategies might include investing in tax-exempt securities, such as municipal bonds or tax-exempt mutual funds, to generate federally tax-exempt interest income.
