What Is Considered a Qualified Investment?
Understand the IRS criteria that define a 'qualified investment' and how this status impacts the tax efficiency of assets in retirement or incentive programs.
A qualified investment is a financial asset that meets specific government criteria, allowing it to be held within an account or program offering tax advantages like tax-deferred growth. The concept is not defined by the type of asset but by its adherence to rules set by the Internal Revenue Service (IRS). An investment is “qualified” because it is permissible within a tax-advantaged structure.
Funds used for these investments are often made with pre-tax dollars, which can lower your taxable income for the year. This structure allows the investment to grow without being subject to annual taxes. These rules are designed to encourage specific behaviors, like saving for retirement or investing in economically distressed areas.
Context in Tax-Advantaged Retirement Accounts
Individuals most often encounter the term “qualified investment” in connection with tax-advantaged retirement accounts. The tax benefits of these accounts are contingent upon following IRS regulations, including rules about what assets can be held inside them. The investments are considered qualified because they are permitted by law, thereby preserving the account’s tax-advantaged status.
These rules apply to a range of retirement plans, including Traditional and Roth Individual Retirement Arrangements (IRAs) and employer-sponsored plans like 401(k)s, 403(b)s, and SIMPLE IRAs. For small business owners and self-employed individuals, Simplified Employee Pension (SEP) IRAs operate on the same principle of holding permissible investments to maintain tax benefits.
The purpose of these regulations is to ensure that tax benefits are used for long-term retirement savings. If an account holder invests in an asset not permitted by the IRS, the transaction is treated as a taxable event. This framework distinguishes between general investing and tax-privileged retirement saving.
Permitted and Prohibited Investments
The IRS has clear guidelines on which assets are permissible to hold within tax-advantaged retirement accounts. Most conventional financial instruments are allowed, including:
- Stocks
- Bonds
- Mutual funds
- Exchange-traded funds (ETFs)
- Certificates of deposit (CDs)
- Annuities
- Certain types of government securities
Conversely, the IRS explicitly prohibits certain assets from being held in accounts like IRAs, most notably “collectibles.” This category includes:
- Works of art
- Rugs and antiques
- Metals and gems
- Stamps and most coins
An exception to the ban on metals and coins exists for certain highly refined gold, silver, platinum, and palladium bullion, as well as specific U.S. Treasury-minted coins. Life insurance contracts are another prohibited category, as retirement funds cannot be used to purchase a life insurance policy within an IRA.
If an individual uses retirement account funds to acquire a prohibited asset, the IRS treats the amount as a distribution at its fair market value. This amount is included in the account holder’s gross income for that year and is subject to income tax. If the account holder is under age 59½, they will also owe a 10% early withdrawal penalty on the amount.
Qualified Opportunity Funds
Separate from retirement accounts, another type of qualified investment is an interest in a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle created to spur economic development in distressed communities designated as Qualified Opportunity Zones. These zones are low-income census tracts certified by the U.S. Department of the Treasury.
Investing in a QOF allows individuals and corporations to receive tax advantages by reinvesting capital gains from a prior investment. When an investor realizes a capital gain from selling an asset, they can defer paying tax on that gain by investing it into a QOF within 180 days. The tax on the original gain is deferred until the QOF investment is sold or December 31, 2026, whichever comes first.
The primary incentive is for long-term investors. If the QOF investment is held for at least 10 years, any appreciation on the QOF investment itself is completely tax-free. This means the investor owes no capital gains tax on the growth of their QOF investment when it is eventually sold.
Tax Reporting Considerations
The tax implications of qualified investments require careful reporting to the IRS. If a retirement account engages in a prohibited transaction, the financial custodian is required to report the event. They will issue Form 1099-R to both the account holder and the IRS, showing the amount treated as a distribution that the taxpayer must then include as income on their Form 1040.
For investments in Qualified Opportunity Funds, specific forms are necessary to claim the associated tax benefits. When an investor defers a capital gain by reinvesting it into a QOF, they must file Form 8949, Sales and Other Dispositions of Capital Assets. This form is used to report the initial sale that generated the gain and to indicate the deferral election.
Additionally, investors must file Form 8997, Initial and Annual Statement of Qualified Opportunity Fund Investments, for the first year they make a QOF investment and for every subsequent year they hold it. This form tracks the basis of the QOF investment, the deferred gain, and the holding period. Failure to file this form can result in penalties and jeopardize the tax benefits.