Final answer:
The income generated by a 401(k) account is taxable when withdrawn. This tax deferral allows for the money to grow without being diminished by yearly taxes, and tax is paid upon retirement distribution, ideally in a lower tax bracket.
Step-by-step explanation:
In a 401(k) plan, the contributions are indeed tax-deductible, which means the income you put into the account is not subject to income tax in the year you earn it. Instead, the taxation of the 401(k) funds is deferred. The income generated by a 401(k) account is taxable when withdrawn. This is because the funds in a 401(k) grow tax-deferred, meaning that no capital gains taxes, dividend income taxes, or interest taxes are paid while the money remains in the account. Upon retirement, when the money is withdrawn, retirees will pay income tax on their distributions, depending on their tax bracket at that time, which ideally would be lower than during their working years. This tax advantage is one of the main benefits of such defined contribution plans, as it allows investments to grow more efficiently and helps to mitigate the inflation costs that might erode the real rates of return over time