Non-Qualifying Investments: Understanding Tax Implications

A non-qualifying investment is a type of investment that can never be subject to any tax benefits. Tax benefits include deductions, exemptions, and credits. The benefits are used to reduce taxable incomeTaxable IncomeTaxable income refers to any individual's or business’ compensation that is used to determine tax liability. The total income amount or gross income is used as the basis to calculate how much the individual or organization owes the government for the specific tax period., and therefore, reduce taxes paid.

Hence, a non-qualified investment is any property that is not a qualified investment for the trust. Generally, if the investment only trades on OTC markets, it is a non-qualified investment.

Summary

• Non-qualifying investments can not receive favorable tax treatment through deductions, exemptions, and credits.
• If a security is traded strictly in over-the-counter markets and not on a designated exchange, it is a non-qualified investment.
• Real estate, artwork, and jewelry are all examples of assets that are non-qualified investments.
• Investors purchase non-qualifying investments because of the flexibility they need to contribute and withdraw freely without penalty. It can increase the investor’s liquidity if their non-qualifying investments are easily marketable.

Examples of Non-Qualified Investments

Over-the-counter securities trading is the exchange of securities between two counterparties without an exchange regulator through dealer networks. The OTC market offers commodities, stocks, debt securities, and derivatives.

Stocks traded on the OTC market usually belong to small companies that lack the resources to be listed on formal exchanges, like the NYSENew York Stock Exchange (NYSE)The New York Stock Exchange (NYSE) is the largest securities exchange in the world, hosting 82% of the S&P 500, as well as 70 of the biggest, NASDAQ, TSX, etc. Additionally, other investments that are non-qualified are real estate, artwork, or jewelry.

What is a Qualified Investment?

A qualified investment is an investment that qualifies for tax benefits and can be invested in tax-sheltered accounts like a tax-free savings account. Examples of qualified investments are:

1. Guaranteed investment contracts (GICs)

Guaranteed investment contracts promise investors a rate of return on their deposit. GICs are low-risk financial products for the risk-averse investor who value stability over return. Generally, the GIC will offer repayment of principal alongside a fixed or floating rate of return for a period.

2. Government bonds

Bonds are financial debt instruments that are purchased to provide defined cash flows over a period of time. The cash flows consist of interest payments and principal repayment at maturity.

Government bonds refer to bonds issued by national governments and are very conservative investments. U.S. Treasury bonds are often considered the risk-free rateRisk-Free RateThe risk-free rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the risk-free rate is commonly considered to equal to the interest paid on a 3-month government Treasury bill, generally the safest investment an investor can make. in financial analysis.

3. Mutual funds

Mutual funds refer to professionally managed investment funds that pool investor money to invest in securities. Mutual funds are very popular due to the diversification benefit, liquidity, and professional maintenance. However, investors are required to pay mutual fund fees and expenses.

4. Securities listed on a designated stock exchange

Securities are tradeable financial instruments offered by publicly accountable enterprises. Popular securities that are often held in tax-deferred accounts include stocks and bonds.

Equity investments offer investors income through capital appreciation and dividend payments. Corporate bonds promise higher yield to investors; it is to compensate investors for the higher risk of potential default.

Penalties for Holding Non-Qualified Investments in Registered Plans

Holding non-qualified investments in registered plans can result in penalties, and additional tax reporting requirements will apply. The consequences of holding a non-qualified investment in a registered plan can be up to a 50% tax on the fair market valueFair Market ValueThe fair market value (of a good or service being exchanged) refers to the price at which both transacting parties agreed to independently. of the non-qualified investment.

The tax is to be applied at the time the non-qualified investment was acquired or the day that it became a non-qualified investment. It can be refunded if it can be proved that the investment was made inadvertently.

Why Do Investors Purchase Non-Qualifying Investments?

Often, registered plans come with annual maximum contributions that can be made towards the plans. Therefore, investors will purchase qualified securities from designated stock exchanges and maximize their contributions to reduce their taxable income.

Moreover, withdrawing money from registered plans can be costly if there are early withdrawal penalties. For example, if an investor contributes a qualifying investment into a (Registered Retirement Savings Plan (RRSP), they cannot withdraw it until retirement age.

Therefore, investors often purchase non-qualifying investments because of the flexibility offered by the investments. Investors are free to hold non-qualified investments outside of tax-sheltered accounts and invest as much as they please with no limit.

Also, investors are more liquid because they can access these assets at any given time; however, it depends on the types of assets held by the investor.

Related Readings

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

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