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:

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Both types of tax-protected accounts can be subject to an additional 10% withdrawal penalty if withdrawn prior to retirement, but these rules are relatively easy to work around.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 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.

  1. Tax-protected growth (guaranteed, but also available to tax-free accounts)
  2. Asset protection for most accounts in most states (guaranteed, but also available to tax-free accounts)
  3. Matching dollars from an employer (not guaranteed, but also available for tax-free account contributions)
  4. 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.

tax deferred accounts


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!