When Tax Deferred Accounts Can Hurt You

Lower your tax bill by creating balance and using asset location strategies

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Socking away all your funds into tax-deferred accounts isn't always the best strategy. Creativ Studio Heinemann/Westend61/GettyImages

Socking away all your money in to tax-deferred plans such as 401(k)s, 403(b)s, 457 plans, and deductible IRAs can be good – to a point. That point ends when you create a situation where 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 all be taxed as ordinary income in the calendar year in which you take the withdrawal.

If you need extra funds for a vacation, new car purchase, or to help out a family member, the excess funds withdrawn may bump you into a higher tax bracket. You could find you are paying 25 cents in taxes, 33 cents in taxes, or even more, on each dollar that you withdraw.

Withdrawals affect Social Security taxation

In addition to the fact that withdrawals from tax deferred accounts are taxed as ordinary income, they can also affect how much of your Social Security income is taxed. Each withdrawal may make more of your Social Security income subject to taxation.

It works this way because there is a formula that determines how much of your Social Security is taxed, and 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 thus may cause more of your Social Security income to be taxed.

A few retires find they pay over 40 cents in taxes per dollar of IRA withdrawals because their IRA withdrawals cause more of their Social Security to be taxed.

This situation cannot always be avoided, but if you plan ahead, 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 plowing all your money into tax-deferred accounts, build up both after-tax accounts to draw from, as well as 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 even 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, by planning ahead you will be creating financial flexibility that may be useful once you are retired.

Use asset location strategies to save even more

As you build up both tax-deferred and after-tax accounts (what I refer to as a "non retirement accounts" which can be a brokerage or mutual fund account that is not designated as an IRA), 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 where you get a 1099 each year.

By locating assets thoughtfuly, 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 diviend 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.