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Taxes on Investments: Mastery Test

Select the correct answer,

Which statement describes the effect of taxes on a traditional 401 (k) retirement account?

A.

A traditional 401 (k) is tax exempt because the income earned isn't taxed until the money is withdrawn.

B.

A traditional 401 (k) is a taxable account because the incomearned is taxed when it is contributed.

C.

A traditional 401 (k) is tax deferred because the income earned isn't taxed until the money is withdrawn.

D.

A traditional 401 (k) is tax exempt because the income earned is never taxed.

C.

A traditional 401 (k) is tax deferred because the income earned isn't taxed until the money is withdrawn.

Explanation:

A traditional 401 (k) retirement plan is one that is sponsored by an employer.

When employees contribute to this plan the income is not subject to tax. Taxation is deferred till the beneficiary wants to make withdrawal.

Withdrawals are taxed at the employee's current income tax rate.

On the other hand the other popular retirement plan is the Roth 401 (k) plan. It is also sponsored by the employer.

One major difference is that the Roth 401 (k) is not tax deferred but are made with after tax dollars. However interest, dividends, and capital gains are tax free.