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.

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.

For high-income individuals, deferring taxation on earnings until distribution from a retirement fund could potentially yield savings in a couple ways. For example, consider a married couple whose gross income would push them just over the break-point to a higher tax bracket. In 2020, a married couple filing jointly would see a rise in tax rate from 24% to 32% on earnings over $326,600. Because the IRS uses marginal tax rates, the couple’s 2020 earnings between $80,250 and $171,050 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 standard limit for individuals contributing to 401(k) plans in 2020 is $19,500, so the couple could trim $39,000 in total off their taxable income, bringing the total number down from $326,600 to $287,600, comfortably within the 24% tax bracket.

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.

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, however, operate a bit differently. When people contribute to Roth IRAs, they use post-tax income. 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 up front 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.