Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Qualifying Investment

What it is:

A qualifying investment is a contribution to a retirement plan made with pre-tax income.

How it works (Example):

For example, let's assume that John participates in his company's 401(k) plan. He socks away $200 per month, and the company automatically deducts the amount from his paycheck. John earns $2,000 every two weeks.

Because the contribution is a qualifying investment, no payroll taxes are withheld from the amount. In other words, if John earns $2,000 every two weeks, his 401(k) contribution of $200 is deducted "off the top" and then the remainder is taxed. This is in contrast to having the whole $2,000 taxed, which would be the case if John were not making contributions to his 401(k) plan. 

As you can see, John is saving money simply by making a qualifying investment because he is taxed on less of his paycheck. Additionally, any money that John makes in his 401(k) plan (from capital gains or dividends, for example) is tax-deferred, meaning that he doesn't have to pay taxes on it in the year in which he earns it. Rather, he pays taxes when he withdraws the money in a few decades. This means that more of his money stays working for him (rather than going to pay taxes), and these savings compound over the years. 

Why it Matters:

Qualifying investments can be made in IRAs, trusts, 529 plans, and many other retirement and savings plans. As the example shows, their tax-deferred status has huge advantages, especially for long-term investors.

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