Qualifying Investment

A qualifying investment is an asset purchased with pretax income—typically through contributions to retirement accounts—whose taxes are deferred until the investor withdraws funds. These investments reduce taxable income in the contribution year and can provide tax advantages by shifting tax liability to retirement, when the investor’s tax rate may be lower.

Key takeaways

• Qualifying investments are funded with pretax dollars and taxed upon withdrawal.
• They incentivize retirement saving by reducing taxable income today.
• Common qualifying vehicles include employer-sponsored retirement plans and traditional IRAs; Roth IRAs are not qualifying investments because contributions are made with after-tax income.

How qualifying investments work

Contributions to qualifying accounts (for example, traditional 401(k)s or IRAs) are made with pretax income, lowering an individual’s taxable income in the year of the contribution. Investment growth inside these accounts is tax-deferred until distributions are taken in retirement. Because U.S. federal income tax is progressive, deferring income can reduce the overall taxes paid if the investor’s retirement tax rate is lower than their pre-retirement rate.

Example

Consider a married couple whose combined income places them near the threshold for a higher marginal tax bracket. By contributing to employer 401(k) plans, each spouse reduces the couple’s taxable income. For example, if the 401(k) contribution limit is $23,000 per person for the year, the couple could defer $46,000 in income by maxing out both plans. That reduction may keep more of their income taxed at a lower marginal rate now, with taxes on those contributions and earnings paid later when they take distributions in retirement—likely at a lower effective tax rate.

Workers age 50 and older can generally make additional catch-up contributions to certain retirement accounts, increasing the amount of pretax income that can be deferred.

Qualifying investments vs. Roth IRAs

• Qualifying (tax-deferred) accounts: Contributions are pretax, and taxes are paid upon withdrawal. Examples include traditional IRAs, 401(k)s, and certain annuities and trusts.
• Roth IRAs: Contributions are made with after-tax dollars; there is no tax deduction in the contribution year. Qualified distributions from a Roth are tax-free, so Roths provide an alternate tax strategy (pay tax now to avoid tax later) rather than tax deferral.

Note: Contribution limits differ by account type. For example, IRA contribution limits are lower than typical defined contribution plan limits.

Financial instruments that commonly qualify for tax deferral

• Annuities
• Bonds
• Exchange-traded funds (ETFs)
• Individual retirement accounts (traditional IRAs)
• Mutual funds
• Registered Retirement Savings Plans (RRSPs) — Canada
• Stocks
• Certain trusts

Benefits of qualifying investments

• Immediate reduction of taxable income in the contribution year
• Tax-deferred growth of investments
• Potential to pay taxes at a lower rate in retirement
• Encourages long-term retirement saving through employer-sponsored and individual retirement plans

Bottom line

A qualifying investment is made with pretax income and offers tax deferral until withdrawal, making it a core tool for retirement planning. Choosing between tax-deferred accounts and after-tax alternatives like Roth IRAs depends on current versus expected future tax rates, contribution limits, and individual retirement goals.