Final answer:
In a traditional IRA, contributions are made with pretax income and are not taxed at the time of deposit, allowing the money to grow tax-deferred. Withdrawals made from a traditional IRA upon retirement are then subject to income tax. This contrasts with a Roth IRA, where contributions are taxed upfront but withdrawals are tax-free.
Step-by-step explanation:
Traditional IRA Contributions and Tax Deferral
For a traditional IRA, contributions are often made with pretax income and are not taxable when they are deposited. These contributions can then grow tax-deferred, which means no taxes are paid on the capital gains or dividend income as long as the money remains in the account. However, when funds are withdrawn from a traditional IRA, typically at retirement, the withdrawn amounts are then subject to income tax. This system contrasts with a Roth IRA, where contributions are made with after-tax dollars, but withdrawals are tax-free.
Defined contribution plans, such as 401(k)s and 403(b)s, function similarly in terms of tax deferral. The money is placed into the account before taxes are taken out, and it grows tax-free until retirement, at which point withdrawals are taxed as income. The significant benefit of these plans is their tax-deferred nature that can lead to a higher net return on savings over the years.