In a 401(k) plan, which is a retirement savings plan sponsored by an employer, tax-deferred growth allows employees to contribute pre-tax earnings to their retirement account. This reduces their taxable income in the years they contribute. Since the funds in the 401(k) are not subject to taxes on capital gains, interest, or dividends annually, all the earnings can be reinvested to generate more growth, taking advantage of the power of compounding over time.
This contrasts with taxable investment accounts, where capital gains and dividends are taxed in the year they are realized, which can erode the growth potential of those investments. Tax-deferred growth is particularly beneficial for long-term savers, as it maximizes the potential for compound growth.
However, it is important to note that when funds are eventually withdrawn from a 401(k) plan during retirement, they are taxed at the individual’s current income tax rate. Additionally, there are rules regarding when and how you can withdraw these funds without penalties, typically centered around reaching the age of 59½. Early withdrawals can result in penalties and immediate taxation, undermining the benefits of tax-deferred growth.