What Is a Non-Qualified Distribution?

A non-qualified distribution is a term that is used to describe funds distributed from different types of financial accounts before the recipient has fully complied with the original terms related to that account. Typically, this type of distribution will trigger some sort of tax obligation, especially when the contributions to the account were not taxed prior to being deposited into that account. While unanticipated circumstances may occur that leads to a non-qualified distribution, this type of withdrawal is normally avoided if at all possible.

One of the more common examples of a non-qualified distribution has to do with early withdrawals of funds from certain types of Individual Retirement Accounts (IRAs) or Individual Savings Accounts (ISAs). While some forms of IRAs and ISAs require that taxes be assessed on contributions before they are deposited into these types of financial accounts, other formats allow contributors to deduct the contributions from their gross income for the tax year. When this is the case, choosing to withdraw the funds before reaching retirement will usually mean that the amount of the non-qualified distribution is treated as taxable income for the year in which the withdrawal occurs. In addition, some retirement accounts of this type may also impose a penalty for that early withdrawal.

The same general set of circumstances can occur when a non-qualified distribution occurs with some sort of education savings account or fund. If the amount of the distribution is greater than the total needed to cover expenses that are considered qualified according to the terms of the account, this could also result in the imposition of penalties and possibly even taxes being due on the unqualified amount. In order to avoid this situation, requests for distributions are often structured to indicate the total amount of the requested distribution will go to cover expenses that are qualified, such as on-campus housing, books, and tuition and fees.

While certain situations may occur that make a non-qualified distribution necessary, it is important to consider all possible alternatives before opting to obtain the needed funds from any type of restricted financial account. Often, the combination of the tax burden that is created plus any fees and penalties that are assessed by the institution that manages the related account or fund is significant. Considering the costs associated with all other options and comparing those costs with the liabilities of receiving an non-qualified distribution can often lead to discovering another strategy that is ultimately more beneficial to the recipient, and makes is possible to avoid the stiff costs of non-qualified withdrawals from a retirement account or an education expense savings account.