Not All Retirement Accounts Should Be Tax-Deferred

Millions of Americans spend money every year on individual retirement accounts (IRA), annuitiesand employer-sponsored pension plans. The tax deferral that these plans and accounts offer is hard to beat, and the Roth IRA and Roth 401(k)s which are now available offer the added benefit of tax-free withdrawals.

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

Key points to remember

  • You can save for retirement in regular taxable accounts and tax-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 do better in regular, taxable accounts.
  • In some cases, your tax bill will be lower on withdrawals from taxable accounts than from tax-deferred accounts.

Best investments for tax-deferred accounts

The first question most people ask themselves 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, which would otherwise be taxable each year. The tax deferral allows these payments to remain whole and continue to accumulate. The tax bill will only come later, when you start making withdrawals.

Two types of investments that lend themselves particularly well to tax-deferred growth are taxable mutual fund and obligations. 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 each year to all shareholders, and unless a fund is held in a tax-deferred account, distributions are considered taxable income for that year. . It doesn’t matter if 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 held in a tax-deferred account of some type.

When taxable accounts can 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. This is because capital gains are currently taxed at a lower rate than pension plan distributions, which are taxed at the same rate as your regular income.

This category includes individuals actionsdurable assets (such as real estate and precious metals) and certain types of mutual funds (such as exchange traded funds and index fundswhich generally generate smaller taxable distributions each year than the other types).

As an added benefit, investments held outside of retirement accounts are not subject to early withdrawal penalties Where minimum required 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, may be best left to grow in a taxable account, as long as you hold them for more than a year. Shares held less than one year prior to sale are subject to the higher tax rates on short-term capital gainscurrently 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 how long they are held.

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

Annuities and municipal bonds

Because annuities are already tax-deferred by design, there is no additional financial benefit to owning them in a tax-deferred retirement account. It is the same with municipal bonds and municipal bond funds, which are generally not subject to local, state, or federal taxes.

If you have a surplus to invest

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

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 401(k) plans, your contributions cannot exceed $20,500 for 2022 (or $27,000 if you’re 50 or older).

This may justify maximizing your tax-deferred accounts first, then putting the rest into regular taxable accounts. The same basic investment principles outlined above will apply, with retirement accounts being best for types of investments that generate a lot of 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) account) is when you get tax relief. With a traditional IRA, you can get a tax deduction for the money you contribute, but your withdrawals will be taxed. With a Roth IRA, you don’t get any initial tax relief, but your withdrawals will be tax-free if you complete some IRS rules. With either type of account, your money grows tax-free in the meantime.

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

Financial planners generally recommend withdrawing money from regular accounts before retirement accounts to preserve the latter’s tax-deferred status as long as possible. Note, however, that after age 72, you must begin receiving the Required Minimum Distributions (RMD) from all traditional (non-Roth) retirement accounts.

How do I determine my required minimum distributions?

The essential

Tax-deferred retirement accounts aren’t the only, or necessarily the best, way to save for retirement. Tax-deferred accounts are best for investments that generate 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 which won’t produce much taxable income, may be best kept in a regular taxable account. You’ll have better access to money if you need it before retirement, and you could potentially pay less tax on that money when you make withdrawals.

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