Qualifying Investment: What It is, How It Works, Example

What Is a Qualifying Investment?

A qualifying investment refers to an investment purchased with pretax income, usually in the form of a contribution to a retirement plan. Funds used to purchase qualified investments do not become subject to taxation until the investor withdraws them.

Key Takeaways

  • Qualifying investments are purchased with pretax income and are not taxed until the investor withdraws them.
  • They provide an incentive to contribute to accounts, such as IRAs, to defer taxes until the funds are withdrawn in retirement.
  • Financial instruments that qualify for deferred taxes include annuities, stocks, bonds, mutual funds, ETFs, IRAs, RRSPs, and some trusts.
  • Roth IRAs require the investor pay taxes upfront and therefore don't meet the guidelines.

How a Qualifying Investment Works

Qualifying investments provide an incentive for individuals to contribute to certain types of savings accounts by deferring taxes until the investor withdraws the funds. Contributions to qualified accounts reduce an individual’s taxable income in a given year, making the investment more attractive than a similar investment in a non-qualified account.

Example of a Qualifying Investment

For high-income individuals, deferring taxation on earnings until the distribution from a retirement fund could potentially yield savings in a couple of ways. For example, consider a married couple whose gross income would push them just over the break-point to a higher tax bracket.

In 2024, a married couple filing jointly would see a rise in tax rate from 24% to 32% on earnings over $383,900. Because the Internal Revenue Service (IRS) uses marginal tax rates, the couple’s 2023 earnings between $201,050 and $383,900 would be taxed at 24%.

Suppose each spouse’s employer offered a 401(k) plan, and the couple maxed out their contributions for the year. The contribution limit established by the IRS caps annual contributions to 401(k) plans in 2024 at $23,000 each. So, the couple could trim $46,000 in total off their 2024 taxable income, bringing the total number down from $383,900 to $337,900, comfortably within the 24% tax bracket.

If the couple had needed to make an additional contribution and they were over the age of 50, they are each allowed by the IRS to make a catch-up contribution of $8,000 in 2024.

After retirement, the taxes the couple will pay on distributions will correspond to their post-retirement income, which likely will be quite a bit less than their combined salaries. To the extent their retirement distributions stay below the threshold for higher income tax brackets, they will profit off the difference between the marginal rates they would have paid in the present and any lower marginal rates they pay in the future.

Qualifying Investments vs. Roth IRAs

Investments qualifying for tax-deferred status typically include annuities, stocks, bonds, IRAs, registered retirement savings plans (RRSPs), and certain types of trusts. Traditional IRAs and variants geared toward self-employed people, such as SEP and SIMPLE IRA plans, all fall under the category of qualifying investments.

Roth IRAs, on the other hand, operate a bit differently. When people contribute to Roth IRAs, they use post-tax income, meaning they don't get a tax deduction in the year of the contribution. Where qualifying investments offer tax advantages by deferring payment of taxes, Roth IRAs offer a tax advantage by allowing contributors to pay a tax on their investment funds upfront in exchange for qualified distributions. Under a Roth IRA, distributions that meet certain criteria avoid any further taxation, eliminating any taxation of the appreciation of contributed funds.

It's important to note that Roth IRAs have lower contribution limits than defined contribution plans such as 401(k)s. Roth and traditional IRAs both have annual contribution limits of $7,000 for 2024. For individuals aged 50 and over, they can deposit a catch-up contribution of $1,000 in 2024.

Article Sources
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  1. Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024.”

  2. Internal Revenue Service. “401(k) Limit Increases to $23,000 for 2024, IRA Limit Rises to $7,000.”

  3. Internal Revenue Service. "Roth Comparison Chart."

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