A qualifying investment refers to an investment purchased with pretax income, typically through contributions to a retirement plan. The crucial benefit here is the deferment of taxes until the investor withdraws the funds, usually upon retirement.
Key Takeaways
- Qualifying investments are purchased with pretax income and don’t get taxed until withdrawal.
- They incentivize contributions to accounts like IRAs and 401(k)s, deferring taxation until retirement.
- Financial instruments that qualify for deferred taxes include annuities, stocks, bonds, mutual funds, ETFs, IRAs, RRSPs, and certain types of trusts.
- Roth IRAs, where taxes are paid upfront, fall outside the traditional qualifying investment guidelines.
How a Qualifying Investment Works
Qualifying investments motivate individuals to contribute to specific savings accounts by offering significant tax deferrals. Contributions to these qualified accounts diminish your taxable income for the year, making such investments more favorable when compared to non-qualified accounts.
Example of a Qualifying Investment
For high-income individuals, the tax deferral from qualifying investments can result in considerable savings. Imagine a married couple whose gross income just exceeds the threshold for a higher tax bracket. In 2024, a married couple filing jointly faces a tax rate rise from 24% to 32% on earnings above $383,900. Under marginal tax rates, earnings between $201,050 and $383,900 would be taxed at 24%.
Suppose each spouse’s employer offers a 401(k) plan, and they maximize their contributions for the year, capped at $23,000 each by the IRS for 2024. The couple can reduce their taxable income by $46,000, adjusting it from $383,900 to $337,900—keeping them within the 24% tax bracket. Additionally, if both spouses are aged 50 or over, the IRS allows an extra catch-up contribution of $8,000 each for 2024.
Upon retiring, the couple’s tax obligations on withdrawals will likely be aligned with their post-retirement income, significantly lower than their combined pre-retirement earnings. As long as their retirement distributions stay below the higher tax brackets, they benefit from the difference between the current and future marginal tax rates.
Qualifying Investments vs. Roth IRAs
Investments that qualify for tax-deferred status generally include annuities, stocks, bonds, IRAs, RRSPs, and some trusts. Traditional IRAs and their self-employed variants such as SEP and SIMPLE IRA plans also fall into this category.
Conversely, Roth IRAs function differently. Contributions are made with post-tax income, offering no tax deduction in the year of contribution. However, they do provide tax advantages by requiring upfront tax payments and allowing tax-free qualified distributions. Roth IRAs also feature lower contribution limits compared to defined contribution plans like 401(k) plans, set at $7,000 annually for 2024. For individuals aged 50 and above, a catch-up contribution limit of $1,000 applies for 2024.
Related Terms: pre-tax income, taxable income, tax bracket, 401(k) plan, marginal tax rates, catch-up contribution, Roth IRA, registered retirement savings plans (RRSPs).
References
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024”.
- Internal Revenue Service. “401(k) Limit Increases to $23,000 for 2024, IRA Limit Rises to $7,000”.
- Internal Revenue Service. “Roth Comparison Chart”.
