By Dr. Jim Dahle, WCI Founder
Today, I'm just going to rant a little bit about a widely held misunderstanding of what a tax-deferred account really is. While people know what it is in a technical sense, they don't conceptualize it properly. Let me see if I can help. Here is the key point of this post:
A tax-deferred account is best thought of as a combination of a tax-free account and an account you are investing on behalf of the US Treasury.
That's it. That's what a tax-deferred account is. But if you don't think of it that way, you'll make some mistakes with your asset allocation, asset location, and retirement spending decisions.
What Is a Tax-Deferred Account?
Some background and more information can be found in the following posts:
- Tax-Deferred Retirement Accounts: A Gift from the Government
- Roth vs. Tax-Deferred: The Critical Concept of Filling the Brackets
- How to Use Tax Diversification to Reduce Taxes Now and in Retirement
- What Is Asset Location? Tax-Efficient Fund Placement
There are three general types of investing accounts.
First, there is a taxable (sometimes called non-qualified) account where you pay taxes on distributions every year and pay capital gains taxes upon selling an asset.
Second, a tax-free (sometimes called a Roth) account contains after-tax money. It grows in a tax-protected manner, so you don't pay taxes on distributions every year and you don't pay capital gains taxes upon selling an asset. Earnings are all tax-free upon withdrawal.
Third, a tax-deferred (sometimes called a traditional) account usually contains pre-tax money but can also contain after-tax money or “basis.” It also grows in a tax-protected manner in that you do not pay taxes on distributions every year and you do not pay capital gains taxes upon selling an asset. The withdrawal of any pre-tax money and all earnings is taxed upon withdrawal at ordinary income tax rates. The withdrawal of basis is tax-free since that money was already taxed when it was originally earned.
Both types of tax-protected accounts can be subject to an additional 10% withdrawal penalty if withdrawn prior to retirement, but these rules are relatively easy to work around.
There are various flavors of these tax-free and tax-deferred accounts including:
- Roth IRAs and Traditional IRAs
- Roth 401(k)s and 401(k)s
- Roth 403(b)s and 403(b)s
- Roth 457(b)s and 457(b)s
- Roth SEP IRAs and SEP IRAs
- Roth SIMPLE IRAs and SIMPLE IRAs
- Roth SIMPLE 401(k)s and SIMPLE 401(k)s
- Defined benefit/Cash balance plans (no Roth version of these yet)
Each of these accounts has its own contribution limits and rules to understand. But at the end of the day, at its most basic level, they are either tax-free accounts or tax-deferred accounts.
The Benefits of a Tax-Deferred Account
There are four benefits of using a tax-deferred account, but only two of them are guaranteed and only one of them is unique in comparison to a tax-free account.
- Tax-protected growth (guaranteed, but also available to tax-free accounts)
- Asset protection for most accounts in most states (guaranteed, but also available to tax-free accounts)
- Matching dollars from an employer (not guaranteed, but also available for tax-free account contributions)
- Potential arbitrage between your tax rate at contribution and your tax rate at withdrawal (not guaranteed, and, in fact, it could be negative—in which case you should use a tax-free account or even a taxable account instead if possible)
What I want you to really concentrate on for this blog post is the first reason: the tax-protected growth. That is the real benefit of using a tax-protected account of any type. That is the main reason why you should use retirement accounts to invest for retirement whenever possible. However, it is not unique to a tax-deferred or a tax-free account. Both accounts enjoy that benefit. For most Americans who are in the 0% qualified dividend and long-term capital gains (LTCG) brackets, their taxable account works very similarly. However, that's not the case for most white coat investors who pay 15%-23.8% in qualified dividends and LTCGs.
A Tax-Deferred Account Is Really 2 Accounts
In reality, when you get that upfront tax deduction for making a tax-deferred retirement account contribution, you're not really saving any money. The tax on that money isn't erased; it is just deferred. It will be paid eventually. In fact, you will (hopefully) pay even MORE in tax down the road than you would have paid this year without that contribution. Basically, the government is saying to you, “Why don't you hold on to that for a while, invest it along with your own money, and then just give me my fair cut whenever you get around to it?”
So, there are two pots of money here. There is your money, and there is money that belongs to the US Treasury.
If your marginal tax rate at contribution was 25% and your marginal tax rate at withdrawal was 25%, three-fourths of the account belongs to you and one-fourth of the account belongs to the government. Conceptually, the portion that belongs to you works precisely the same as your tax-free accounts. It grows tax-protected and it comes out tax-free. The portion that belongs to the US Treasury is not yours and never was yours. You don't get the principal, and you don't get the earnings. If you're lucky and you plan well, you could acquire some portion of the government's account. This is the “arbitrage” mentioned above as a potential benefit of a tax-deferred account. But when making decisions about the account once the contribution is made, you can pretty much ignore that aspect. So again, let me repeat how you should think about your tax-deferred account:
A tax-deferred account is best thought of as a combination of a tax-free account and an account you are investing on behalf of the US Treasury.
The Objections and Why They Don't Matter Much
Some people object to thinking about a tax-deferred account this way for various reasons. Let's go through them and show why they don't matter all that much.
I Don't Actually Know My Tax Rate at Withdrawal Yet
While it is true that your tax-deferred account withdrawal tax rate could be higher or lower than you might currently expect due to personal financial changes or general tax rate changes, that doesn't affect the fact that some portion of that account belongs to the government. You make your best estimate and go with it. You can still conceptualize the tax-deferred account as two accounts.
Tax-Free Accounts Don't Have RMDs
While it is true that (at least since Secure Act 2.0 passed) only tax-deferred accounts have Required Minimum Distributions (RMDs), those are being pushed back to age 75. At that point, it doesn't matter much. The average life expectancy in the US is 77 years. If you make it to age 60, a man, on average, will live to age 80, and a woman will live to age 83. That's only 5-8 years of taking RMDs. If a man retired at 55 and lives to 80, he would only be required to take RMDs for 20% of his retirement (i.e. five out of 25 years). It's just not much of a factor. Besides, the RMD at age 75 is only 4.07% of the prior year's balance. You're probably spending at least that much anyway—or, at least, you should be. You're not immortal. Even if you don't want to spend it, you can just give the government its portion and reinvest your portion in a taxable account.
Roth IRAs Don't Get Asset Protection in My State
Yes, there are a few states where Roth IRAs get less protection than traditional IRAs, just like there are a few states where IRAs get less protection than 401(k)s. It's really not a huge deal, though. The likelihood of you getting sued and then being given an above-policy limits judgment that wouldn't be reduced to policy limits on appeal—especially after you stop practicing and retire—is so rare.
The IRS Considers the Entire IRA My Money When Calculating Estate Taxes
While true, this issue doesn't apply to the vast majority of people. If it does apply to you and you have any charitable bones in your body, you simply use the tax-deferred money for your charitable bequests. Voila, no estate taxes due on the government portion of that IRA.
Additional Taxable Income in Retirement Can Increase the Cost of Healthcare Due to Phaseouts
Phaseouts do screw up this concept a bit. For example, if you have more taxable income due to large tax-deferred account withdrawals, you might have to pay more for Medicare due to IRMAA or get a smaller PPACA subsidy. For most people, these are pretty minor objections, but it's worth paying attention to them if they apply to you.
What This Concept Means
OK, now that I've explained the concept and why most objections to it are silly, let's talk about what it means and what happens when people DON'T conceptualize their tax-deferred accounts in this way.
Asset Allocation in a Tax-Deferred Account
If you mistakenly assume you own the entire tax-deferred account, you might not have the asset allocation you think you have. For example, let's say you have $1 million in a tax-free account and $2 million in a tax-deferred account of which you figure you own 75%. You've decided you want a 60/40 allocation. You fill your entire tax-free account and $800,000 of your tax-deferred account with stocks and the remaining $1.2 million of that tax-deferred account with bonds. What is your actual asset allocation?
In actuality, you have $2.5 million, of which $1.6 million (64%) is stocks and $900,000 (36%) is bonds. The US Treasury has $500,000, of which $200,000 is stocks and $300,000 is bonds. Your asset allocation is not 60/40. Yours is 64/36 (and the government's is 40/60, if you care.) You're taking more risk than you thought. This can make an even bigger difference when you start looking at smaller asset classes which may be entirely in just one type of account. For instance, maybe you wanted 5% of your portfolio in microcap stocks and 5% in REITs, but you put the microcaps in your tax-free account and your REITs in a tax-deferred account. On an after-tax basis, you do not have the same amount of money invested in both of those asset classes.
I'm not going to pretend that most people tax-adjust their tax-deferred or taxable accounts (and I don't either), but that would be the academically correct way to look at your asset allocation. If you're going to ignore this issue, you'd better be OK with your asset allocation being “close enough” instead of exact.
Asset Location
I see this one all the time. “Put your stocks in your tax-free account and your bonds in your tax-deferred account because you want a larger tax-free account.” Now that you understand what a tax-deferred account actually is, you know how stupid this statement is. It gets worse, though. People deliberately talk about NOT wanting their tax-deferred account to grow so they don't have to pay more in taxes. That's just as dumb as trying not to make money because you don't want to pay taxes. As a general rule, paying more tax is a good thing because it means you have more money after-tax. That's certainly the case with a tax-deferred account.
It gets even weirder. Consider this question posted in a thread on the Bogleheads forum:
“Just wondering if we should end up with just Roth and taxable. We can pull from Trad Ira and taxable to stay at the ACA income level till we are both over 65 and on medicare. Plus do some Roth conversion on the younger one of us. We would end up with just Roth and taxable. The only problem I see is bonds/cash would have to be in Roth and/or taxable.”
Ignoring the main point of the question, I want to focus on the last line. This poor investor thinks he literally SHOULD NOT OWN BONDS OUTSIDE OF A TAX-DEFERRED ACCOUNT. That's messed up. I mean, carry it out to its logical conclusion in an extreme situation such as someone with 90% of their portfolio in a taxable account. Don't let the tax tail (or the asset location tail) wag the asset allocation dog.
It's OK to put bonds in your Roth IRA. Yes, putting stocks in there instead is likely to lead to more money down the road but only because you're taking on more risk on an after-tax basis. Your tax-deferred account is basically just a Roth IRA plus the account you invest on behalf of the government.
Einstein said, “Everything should be made as simple as possible but no simpler.” Asset location is admittedly complicated, but using rules of thumb like “bonds go in tax-deferred” is wrong because it is making things simpler than is really possible. At low-interest rates, perhaps you should even put your bonds in a taxable account.
Retirement Spending
It is also important to remember this concept when trying to decide how much of your portfolio you can spend. If you mistakenly assume that YOU own that government account, you might retire too soon or spend too much in retirement. Remember the 4% rule guideline includes everything. You can only withdraw about 4% of your initial portfolio adjusted upward with inflation each year and, with high probability, expect it to last 30+ years. That 4% has to include your housing costs, your food expenses, your healthcare expenses, investment fees (a 1% AUM fee could eat up 25% of retirement income), and taxes. Essentially, you should not even consider the government portion of that tax-deferred account as part of your nest egg when doing your calculations. Think you have a $2 million IRA? Nope. You really have something like a $1.5 million IRA. Plan accordingly.
It is not enough just to know how a tax-deferred account works. You also need to conceptualize it properly to make your financial planning and investing decisions correctly.
What do you think? Have you made any of these mistakes before? Comment below!
If you aren’t a high spender (perhaps already have a paid off house) you could be withdrawing from the 401k and pay zero taxes. See the famous thread thread on bogleheads by livesoft how to pay zero taxes on $100k in expenses in retirement.
Here’s one version of that: https://www.bogleheads.org/forum/viewtopic.php?t=87471
Yes, livesoft made a lot of heads spin around with that thread. I would recommend anyone with a taxable account to read his approach to TLH and Real Bad Day investing.
“There are four benefits of using a tax-deferred account” – I’d also add, for people investing in an employer plan: the automated nature of investing via payroll deductions. Sure, you can set that up on your own, but few do. And for lots of people, without automating it, they won’t sock away as much, they’ll spend it. I think overall this may be the largest benefit, dollar-wise, for most people.
Not sure that’s a benefit of a tax-deferred account so much as a benefit of an employer provided account.
Ok Jim, you “win.” There’s a lot of overlap in that Venn diagram, but I will refrain from engaging with the blog in a collaborative and constructive way unless the language would withstand interrogation in federal court. You made it awfully un-fun to participate.
Sorry to take the fun out of it.
I have been putting away money in my taxable account, every pay period, for decades. Easier to set up outside a retirement account as inside. Fewer rules, no caps on what you can contribute.
Great. Hopefully one saves enough to be able to max out retirement accounts and save in taxable too.
Perhaps I am missing something or in error, but I thought one of the bigger benefits of a tax-deferred account was the tax rate arbitrage. That is, the difference between the marginal tax rate during one’s high earning years, and the effective tax rate during the retirement years.
For example, I’ll use a married physician with an adjusted gross income of $462,500. If he put $50,000 in tax-deferred accounts, that money is not in the AGI, and is not taxed at 35%. When he retires and desires a draw of $120,000 per year from that account, he would pay $17,015 (if my figures are correct) in tax. That is an effective tax rate of 14%.
Your point is right about that 14% of the account being the government’s money. But it’s not 35% and I wouldn’t under-appreciate that.
Paying 14% is a whole lot better than paying 35%, isn’t it?
The catch here is taxation of Social Security benefits. With $50k of benefits and $34k of other income, a married filing jointly couple will be paying 22.2% in marginal federal income taxes. (See here for why: https://www.bogleheads.org/wiki/Taxation_of_Social_Security_benefits) Many will be at least ‘briefly’ paying 40.7%.
Absolutely. Many people will have a huge delta between the tax rates. And when calculating how much the government owns, the tax rate at withdrawal is the one that matters.
You are comparing the 35% marginal rate with the average tax rate. The marginal tax rate on $120,000 income is 22%, not 14%.
The comparison is correct when you consider the following. In the example, every dollar put in the tax-deferred account is spared the 35% tax. Yet when you take the dollars out it retirement, only the last few thousand ($89,451-$120,000) are taxed at 22%, making the average tax rate the best way of looking at those retirement withdrawals.
I agree with the thesis of the post, but I doubt that most here will be ‘losing’ 25% of their tax-deferred balances to taxes.
Apart from the taxation of Social Security benefits, it takes around $400,000 of taxable income for a married filing jointly couple to max out the 24% bracket. That’s not going to happen with a $2 million tax-deferred account. Assuming 4% withdrawals, you’d need $10 million in tax-deferred accounts to reach that point. And, obviously, not all of the $400k would be taxed at 24%.
Long-term capital gains are taxed at a maximum of 20%, and the cost basis of sold investments is obviously not taxed at all.
Some people are single. Some become widowed. Some have high state tax. Some people have pensions. I don’t know what most here will have as their marginal tax rate in retirement. Best to run the numbers yourself.
If you don’t like whatever number I pulled out for an example, insert your own and redo the math so it makes better sense to you.
Also, the government dors not care how much you WANT to spend, it forces you yo take out at least the RMD amount. You have to pay the tax, no matter what you do with the rest of it. The RMD amount goes over 4% at age 75 and increases from there. So RMDs easily can be that much or more.
People with large tax deferred accounts may also have income-producing taxable investments. Their income need mot be limited to SS and RMDs.
The RMD percentage increases over time, but unless your investments are growing faster than that, the inflation-adjusted dollar amount of the RMDs can easily be flat or declining. And most dividends will be taxed at LTCG rates. But yes, it’s possible for some folks with very large tax-deferred balances to pay an effective 25% or higher tax rate on the withdrawals.
By your 90s, the inflation adjusted dollar amount of an account is almost surely declining due to RMDs. Not so much in your 70s though when the RMD is only about 4%. That’s kind of the point though, right? You’ve maxed out the benefits of the tax deferred account and now must either spend it (the whole point of a retirement account), give it away (preferably via QCDs) or reinvest it in taxable for your heirs.
It would take a heck of a tax deferred account to pay 25%+ in federal income tax on withdrawals if that were your only source of income. The 32% bracket doesn’t even start until $362K for MFJ. Add another $26K or so for the standard deduction and we’re talking about close to $10 million in today’s dollars for a 75 year old. How many 75 year olds do you know with a $10M IRA?
I was thinking in terms of combined federal, state, and potentially IRMAA taxation to arrive at 25%, not just federal.
And yes, if you live to be in your 90s and are in a high tax bracket due to RMDs, you’ve ‘won the funded retirement game’ by anyone’s definition of the phrase.
All true. But one doesn’t have to spend the RMD. It can just be reinvested in taxable if you want to be the richest guy in the graveyard.
24% bracket limit for married filing jointly is $364,200. But remember, if the tax cuts put in during the Trump administration are not extended, they will revert back to old higher rates the end of 2025.
Don’t forget the standard deduction, which is $27,700 for MFJ in 2023. But yes, tax rates might revert to their prior, higher levels. We’ll see. Elections matter.
Yea, there’s a lot riding on the 2024 elections tax-wise.
I really enjoyed this post. I’ve spent several decades of my career designing deferred compensation strategies for Fortune 500 company executives and executive and physicians in large healthcare organizations.
I love tax strategies and planning around them. I spoke at the last WCI conference as one of WCI’s recommend financial planning firms on tax savings. “It’s not how much you accumulate, but how much you keep after taxes.” I recently also covered the top at an American College for Physician Leadership (AAPL) webinar. https://myfinancialcoach.com/aapl-webinar-replay/
Under the employer tax deferred compensation programs, one major risk is your deferrals and earnings are “subject to the claims of the employer’s general creditors.” One major physician organization just filed for bankruptcy which means the participants are standing in line as creditors. 457(b) retirement plans have the same issue. I’m working with one of their competitors on a solution to protect those assets in their plan.
Also, one overlooked tax strategy with retirement plans is the Source Tax Rules. Since 1996, federal law (4 U.S.C. § 114 (“Pension Source Law”)) has preempted states from imposing income taxes on “any retirement income of an individual who is not a resident or domiciliary of such state (as determined under the laws of such State).” The Pension Source Law applies to “retirement income,” which means plans qualified under the Internal Revenue Code and specified nonqualified plans — namely certain annuitized nonqualified plans that pay out for more than 10 years and excess benefit plans. If you defer money in California, and qualify under the Source Rules, and take retirement payments in Nevada (a zero-income tax state) you never have to pay California taxes. That’s as much as a 13.3% savings.
There are also many after-tax strategies like Roth plans, but without limits, where money can come out tax free.
With this concept in mind, this seems to make QCDs very powerful for those that are charitably inclined. Correct?
Absolutely. QCDs are the very best way for the 70+ charitably inclined to give.
Ideally, should one (should my fam) be using a similar part-of-this-is-mine/part-of-this-is-the-government’s lens when looking at my long-held taxable accounts? For instance, we have some taxable funds that are now almost 20-years-old and the majority of the equity is now a LT gain.
For example, say a taxable fund is $1M total with $300K original investment; $700K gains. Should we not apply this same 25% government/75% mine rule-of-thumb to the $700K?
It would be the same if you were to sell it. However unlike the tax deferred accounts, you have the the option of holding the taxable account until death. If you die holding tax deferred assets, the government will still force out taxable income. If you die holding taxable assets, not only is there no tax due but there is a stepped up basis. Your heirs can sell with no capital gains taxes.
makes sense–thanks!
Certainly the academically correct way of thinking about it (assuming you expect to actually sell the shares at some point) but so much more difficult to do accurately for most that nobody bothers.
I am confused by the use of 1.85 multiplier and adding OI and QD to determine marginal tax rate. My understanding of marginal tax rate is that it is the highest tax rate one pays. For example, if one is in the 22% tax bracket, that is their MTR. You do not pay qualified dividend rate and OI tax rate. It is one or the other.
Please explain. Thanks
I’m not sure what you’re referring to. I searched the document for 1.85 and couldn’t find any reference to it.
My question related to an article that I linked to from your article. At least that was what I thought. However, I am unable to find it now. Sorry to trouble you.
Thanks,
John
I believe the 1.85 multiplier is recognizing that for taxpayers in a certain income range, one additional dollar of income causes an additional 85 cents of Social Security benefits to be taxed.
It can be a very hefty marginal tax rate in that income range. Keep in mind that’s a pretty low income we’re talking about though.
trying to subscribe to get follow-up comments without leaving a comment but keep getting ‘Challenge answer is not correct’ when all there is is a box to check, no ‘challenge’ to answer…
I guess I’m all set by adding this message, but a heads up to whoever might address this.
Hmmm…not sure what’s going on. Maybe the software doesn’t allow you to subscribe without a comment. I’ll have our tech folks check on it.