Maximize Your Retirement Savings: When Taxable Accounts Outshine Tax-Sheltered Ones

While tax-sheltered retirement accounts often provide valuable tax advantages, they aren't always the most cost-effective choice for every investment type.

Every year, millions of Americans contribute to individual retirement accounts (IRAs), annuities, and employer-sponsored retirement plans. These tax-deferred accounts can offer substantial savings if your retirement tax rate is lower than your current rate. Roth IRAs and Roth 401(k)s differ by offering no immediate tax deduction but allow for tax-free withdrawals under qualifying conditions.

However, there are situations where distributions from retirement accounts may result in higher taxes than investments held in taxable accounts. This guide explores when keeping assets in taxable accounts might be a smarter move for your retirement savings.

Key Insights

• Retirement savings can be held in both taxable and tax-sheltered accounts.
• Investments generating frequent taxable income benefit most from tax-sheltered accounts.
• Assets expected to appreciate significantly without producing much taxable income often perform better in taxable accounts.
• In some cases, taxable accounts can lead to lower taxes upon withdrawal compared to tax-sheltered accounts.

When Tax-Sheltered Accounts Are Advantageous

Tax-sheltered accounts shine when housing investments that produce regular taxable income like interest, dividends, or capital gains distributions. The tax deferral allows these earnings to compound without annual tax erosion. Traditional IRAs and 401(k)s delay taxes until withdrawal, while Roth accounts provide tax-free withdrawals after meeting IRS criteria.

Mutual funds and bonds are prime examples of investments that generate frequent taxable distributions, making them ideal for tax-sheltered accounts. Mutual funds must distribute capital gains annually, which are taxable if held outside of tax-advantaged accounts. Bonds pay regular interest that is taxable unless sheltered.

When Taxable Accounts Make More Sense

Investments that primarily appreciate in value without generating substantial taxable income are often better suited for taxable accounts. Capital gains from these investments benefit from lower tax rates than ordinary income tax rates applied to retirement account withdrawals.

Examples include individual stocks, real estate, precious metals, and certain mutual funds like index funds and ETFs, which typically produce fewer taxable distributions.

Additional Advantages

Funds in taxable accounts are not subject to early withdrawal penalties or required minimum distributions (RMDs), offering greater flexibility to access your money anytime.

Individual Stocks

Stocks with low or no dividends can grow tax-efficiently in taxable accounts if held for over a year, qualifying for favorable long-term capital gains rates. Selling stocks within retirement accounts results in taxation as ordinary income regardless of holding period, often leading to higher taxes for most investors.

Annuities and Municipal Bonds

Annuities already provide tax deferral, so placing them inside tax-sheltered accounts offers little additional benefit. Similarly, municipal bonds and municipal bond funds are typically exempt from federal, state, and local taxes, making taxable accounts suitable for holding them.

Investing Beyond Retirement Account Limits

If your annual investment contributions exceed retirement account limits, it’s wise to max out tax-sheltered accounts first and allocate excess funds to taxable accounts. For instance, in 2024, IRA contributions cap at $7,000 ($8,000 if 50 or older), and 401(k) limits are $23,000 ($30,500 if 50 or older). These limits increase slightly in 2025.

Following the investment principles mentioned above will help you optimize returns across both account types.

Traditional IRA vs. Roth IRA: Understanding the Tax Timing

The key difference lies in when you receive tax benefits. Traditional IRAs and 401(k)s offer tax deductions upfront but tax withdrawals as ordinary income. Roth accounts provide no immediate deduction but allow for tax-free withdrawals if IRS conditions are met. Both grow tax-deferred during the accumulation phase.

Withdrawal Strategies After Retirement

Financial advisors often recommend withdrawing from taxable accounts first to preserve tax-sheltered funds longer. However, traditional retirement accounts require RMDs starting at age 72, which must be factored into your withdrawal plan.

Calculating Required Minimum Distributions

Your RMD amounts depend on your account balances and life expectancy. The IRS provides detailed guidance and worksheets in Publication 590-B to help calculate these distributions accurately.

Final Thoughts

Tax-sheltered retirement accounts are valuable but not the sole solution for retirement savings. They work best for investments generating significant taxable income annually. For assets expected to appreciate without producing much taxable income, taxable accounts can offer better growth potential, greater liquidity, and potentially lower taxes upon withdrawal. A balanced approach tailored to your investment types and tax situation can maximize your retirement readiness.

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