Why Tax-Deferred Accounts Can Present Problems When You Retire

Lower Your Tax Bill by Creating Balance

A young woman sitting on the floor with a laptop and paperwork checking her 401k.
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Socking away all your money into tax-deferred plans like 401(k)s, 403(b)s, 457 plans, and deductible IRAs can be good until you create a situation in which all your financial assets are inside tax-deferred accounts. This can cause problems once you’re retired because of the way retirement income is taxed.

Taxes on Withdrawals Matter

When you withdraw money from tax-deferred accounts, it will be taxed as ordinary income in the calendar year in which you make the withdrawal. If you need extra funds for a vacation, a new car, or to help a family member, the excess funds withdrawn may bump you into a higher tax bracket. For example, a taxpayer who files single returns can withdraw up to $9,950 in the 2021 tax year and remain in the 10% tax bracket. After that threshold, withdrawals will start being taxed at 12%, until the next threshold is hit at $40,525.

Withdrawals only count toward taxable income when you're withdrawing from a tax-deferred account. Withdraws from after-tax accounts, like Roth IRAs, aren't taxed.

Withdrawals Affect Social Security Taxation

In addition to considering how withdrawals will affect your tax bracket, you'll also need to be aware of how withdrawals can affect the way your Social Security income is taxed. Too many withdrawals may make more of your Social Security income subject to taxation.

There is a formula that determines how much of your Social Security is taxed. One of the components of this formula is the amount of “other income” you have. Additional IRA withdrawals increase the amount of other income and may cause more of your Social Security income to be taxed.

Depending on the amount of your other income, you either pay taxes on 50% of your Social Security income or 85% of your Social Security income. By carefully planning the way you withdraw from retirement accounts, you may be able to lower the tax consequence by saving in a tax-smart way.

Building Diverse Tax Buckets Can Lower Your Lifetime Tax Bill

Rather than putting all your money into tax-deferred accounts, build up both after-tax and tax-deferred accounts. Work with a CPA or retirement income planner to estimate your tax bracket in retirement. If it will be about the same or higher than it is now, consider funding Roth accounts instead of tax-deductible IRAs and making Roth contributions to your 401(k) or 403(b) plan (if the plan allows this).

As you near retirement, it will be important to have a balance of after-tax and pre-tax money. Even if you are foregoing some deductions now, you will be creating financial flexibility that may be useful once you are retired by planning ahead.

Use Asset Location Strategies to Save Even More

As you build up tax-deferred and after-tax accounts, you can use asset location strategies to make your plan even more tax-friendly.

Asset location is the process of strategically choosing to "locate" high turnover, high income-generating assets inside tax-deferred accounts, and placing low turnover investments that generate qualified dividend and long-term capital gains in your non-retirement accounts (the ones that send you a 1099 each year).

By locating assets thoughtfully, investments like taxable bonds (which generate interest income) and small-cap stock funds (which typically have high turnover and generate more short-term gains) can kick off this type of investment income inside of tax-deferred accounts where you pay no tax until you withdraw funds—regardless of the underlying investment income activity.

Tax-efficient holdings like tax-managed funds, large-cap stock funds, and dividend income funds can be located in your non-retirement accounts where you can take advantage of the lower tax rate that applies to qualified dividends and long-term capital gains.

If these same holdings are owned inside your retirement accounts the qualified dividends and long-term gains will end up being taxed at the higher ordinary income tax rate—as all withdrawals from tax-deferred retirement accounts are reported as ordinary taxable income and the withdrawal will not retain the underlying character of the income such as dividend or capital gain.

Bottom Line

Taxes matter. By creating a balance of tax-deferred and after-tax investment accounts, and locating investment holdings inside these accounts in a tax-efficient way, you can save multiple thousands in taxes over your investing lifetime.

The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.