Which of the following best describes the primary tax advantage of investing in a 401(k) or IRA?

• A. All withdrawals are tax-free regardless of age or income.
• B. Investment earnings are taxed annually at a reduced rate.
• C. Contributions are taxed twice, but withdrawals are tax-free.
• D. Contributions may be tax-deductible, and investment earnings grow tax-deferred until withdrawal.

Answer: (D)

Verified step by step guidance

1. Understand the concept of tax-advantaged accounts like 401(k) and IRA. These accounts are designed to encourage retirement savings by offering tax benefits.
2. Learn about tax-deductible contributions: In traditional 401(k) and IRA accounts, contributions may be deducted from taxable income, reducing the amount of income subject to tax in the year the contribution is made.
3. Understand tax-deferred growth: Investment earnings within these accounts (such as interest, dividends, and capital gains) are not taxed annually. Instead, taxes are deferred until funds are withdrawn, typically during retirement.
4. Recognize the withdrawal rules: Withdrawals from traditional 401(k) and IRA accounts are taxed as ordinary income. Early withdrawals (before age 59½) may also incur penalties unless exceptions apply.
5. Compare this to other options: Unlike Roth accounts, where contributions are made with after-tax dollars and qualified withdrawals are tax-free, traditional accounts focus on deferring taxes to a later date, which can be advantageous depending on your current and future tax brackets.