I understand that 401k contributions are treated as deferred income so they will be taxed at my (presumably lower) tax rate when I am retired and over the age cutoff. I also understand that this taxation applies to all of the investment returns that accrue on my 401k contributions between now and my retirement. But what happened to the capital gains (other investment) taxes that I would have to pay on investments that I made with my after-tax income? It seems that the 401k is a way to avoid paying capital gains taxes and other investment taxes, since all I do is pay the income tax. To illustrate what I am asking, assume that my current and retirement tax rates are both 10% so the deferred tax benefit is absent. Also assume that I have the same investment option inside and outside the 401k and it doubles my initial investment. I am comparing two scenarios for what I could do with $1000:1) Put it in the 401k. My $1000 grows to 2x$1000=$2000. Subtract 10% income tax on all of it. I end up with $1800. 2) Keep it outside of the 401k. My $1000 gets taxed and I have $900. My $900 grows to 2x$900=$1800, but now I have to pay 15% capital gains tax = 0.15*$900. I end up with less: $900+$900*(1-0.15)=$1665. It seems that the 401k investments are exempt from investment taxes. Is this actually correct or is there some catch in the withdrawal process? NOTE: I am assume a withdrawal after the age cutoff (59 1/2), so there are no penalties.
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