Not all retirement accounts should be tax-deferred

Millions of Americans throw away money every year in individual retirement accounts (IRAs), annuities, and employer-sponsored retirement plans. The tax deferral these plans and accounts provide is hard to beat, and the Roth IRAs and Roth 401(k) now available offer the added benefit of tax-free withdrawals.

However, there are times when the taxes you’ll have to pay on retirement plan distributions may be greater than the taxes you’d have to pay on unprotected, taxable investments. In this article, we’ll explore when it might be best to leave your assets exposed to the taxman while you’re saving for retirement.

Key points

  • You can save for retirement in both regular taxable accounts and deferred retirement accounts.
  • Investments that generate a lot of taxable income are best for tax-deferred accounts.
  • Investments that don’t produce much taxable income but are likely to grow in value may fare better in regular, taxable accounts.
  • In some cases, your tax bill will be lower on withdrawals from taxable rather than deferred accounts.

Best Investments for Tax Deferred Accounts

The first question most people ask is, “What types of investments should I put in tax-deferred accounts?” The answer is that tax-deferred accounts offer the greatest benefit when holding investments that generate frequent cash flows, or distributions, that would otherwise be taxable every year. Tax deferral allows those payments to remain in full and continue to compound. The tax account will only arrive later, when you start making withdrawals.

Two types of investments that are particularly well suited for tax-deferred growth are taxable mutual funds and bonds. They produce the largest and most frequent taxable distributions, such as interest, dividend and capital gains distributions.

By law, mutual funds must distribute their capital gains annually to all shareholders, and unless a fund is held in a tax-deferred account, the distributions are considered taxable income for that year. This is regardless of whether the investor takes distributions in cash or simply reinvests them in more shares. Similarly, government and corporate bonds pay regular interest that is taxable, unless held in a tax-deferred account of some kind.

When taxable accounts may make more sense

There are several types of investments that can grow reasonably efficiently even if they are taxable. In general, any investment or security that qualifies for capital gains treatment at tax time is a good candidate for a taxable account. That’s because capital gains are currently subject to a lower tax rate than retirement plan distributions, which are taxed at the same rate as regular income.

This category includes individual stocks, tangible assets (such as real estate and precious metals), and certain types of mutual funds (such as exchange-traded funds and index funds, which typically generate lower taxable distributions each year than other types).

As an added benefit, investments held outside retirement accounts are not subject to early withdrawal penalties or required minimum distributions. You can withdraw money whenever you want or never withdraw it at all.

Individual actions

Stocks, especially those that pay little or no dividends, are best allowed to grow in a taxable account, as long as you keep them for more than a year. Shares held less than a year before the sale are subject to the highest rates of tax on short-term capital gains, currently the same rates that apply to your ordinary income.

However, if you hold individual stocks in a retirement account, the proceeds you receive when you sell them will be taxed as ordinary income, regardless of their holding period.

As a result, investors in all but the lowest tax brackets will usually pay less tax on the sale of stocks held outside of their retirement accounts.

Municipal annuities and bonds

Since annuities are already tax-deferred by design, there is no additional financial benefit to owning them within a tax-deferred retirement account. The same is true for municipal bonds and municipal bond funds, which are generally not subject to local, state or federal taxes.

If you have excess to invest

This is not a “problem” that many of us will face. But if you’re lucky enough to have a large amount of money to invest for retirement in any given year, you may find that it exceeds the limits for retirement accounts.

For 2022, for example, your traditional and Roth IRA contributions can’t exceed $6,000 combined (or $7,000 if you’re age 50 or older). For 2023, the contribution limit rises to $6,500 (or $7,500 for those over 50).

In the case of 401(k) plans, your contributions can’t exceed $20,500 for 2022 (or $27,000 if you’re age 50 or older). For 2023, the limit rises to $22,500 (or $30,000 for those over 50).

This can support maxing out your tax-deferred accounts first and then putting the remainder into regular taxable accounts. The same basic investment principles described above will apply, with retirement accounts being best for the types of investments that generate otherwise taxable income each year.

What is the difference between a traditional IRA and a Roth IRA?

The main difference between a traditional IRA and a Roth IRA (as well as between a traditional account and a Roth 401(k)) is when you receive a tax break. With a traditional IRA, you can get a tax break for the money you contribute, but your withdrawals will be taxed. With a Roth IRA, you don’t get an upfront tax deduction, but your withdrawals will be tax-free if you meet certain IRS rules. With both account types, your money grows tax-deferred in the meantime.

After retirement, should I first withdraw money from my retirement or regular accounts?

Financial planners generally recommend withdrawing money from regular accounts before retirement accounts in order to preserve the latter’s tax-deferred status for as long as possible. Note, however, that after age 72 you need to start withdrawing required minimum distributions (RMD) from any traditional (non-Roth) retirement account.

How do I determine my minimum required deployments?

The bottom line

Deferred retirement accounts aren’t the only, or necessarily the best, way to save for retirement. Tax-deferred accounts make the most sense for investments that generate a lot of income that would otherwise be taxable in the year you receive it. Investments that you expect to increase in value over time, but which won’t produce much taxable income, may be best left in a regular taxable account. You’ll have greater access to money if you need it before retirement, and may ultimately pay less tax when you make withdrawals.

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