Not All Retirement Accounts Should Be Tax-Deferred

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

However, there are times when the taxes you’ll owe on retirement-plan distributions can be greater than the tax you’d have to pay on un-sheltered, taxable investments. In this article, we’ll explore when it may be better to leave your assets exposed to the tax man as you’re saving for retirement.

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 provide the greatest benefit when they hold investments that generate frequent cash flow, or distributions, that would otherwise be taxable each year. Tax-deferral allows those payments to remain whole and continue to compound. The tax bill will only come later, when you begin to make 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, dividends, 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. That’s regardless of whether the investor takes the distributions in cash or simply reinvests them in more shares. Similarly, government and corporate bonds pay regular interest that is taxable, unless they’re held in a tax-deferred account of some type.

When Taxable Accounts May Make More Sense

There are several types of investments that can grow with reasonable efficiency even though 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 your regular income.

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

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

Individual Stocks

Stocks, particularly those that pay little or nothing in the way of dividends, can be better left to grow in a taxable account, as long as you hold them for more than a year. Stocks held less than a year before they’re sold are subject to the higher tax rates 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 bracket will usually pay less tax on the sale of stock held outside of their retirement accounts.

Annuities and Municipal Bonds

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

If You Have an Excess to Invest

This isn’t a “problem” that a lot of us will face. But if you’re fortunate enough to have a great deal of money to invest for retirement in any particular year, you could find that it exceeds the limits for retirement accounts.

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

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

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

The Bottom Line

Tax-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 spin off a lot of income that would otherwise be taxable in the year you receive it. Investments that you expect to grow in value over time, but that won’t produce much taxable income, may be better left in an ordinary, taxable account. You’ll have greater access to the money if you need it before retirement, and you may ultimately pay less tax on it when you make withdrawals.