Not All Retirement Accounts Should Be Tax-Deferred

Millions of Americans nationwide are socking away money in all forms of IRAs, annuities and employer-sponsored retirement plans, both qualified and non-qualified. The tax deferral that these plans and accounts offer is hard to beat in many cases, and the Roth IRAs and Roth 401(k)s that are now available can be particularly effective in sheltering after-tax income. However, there are times when the tax from retirement-plan distributions can be greater than the tax that would be realized from unsheltered taxable investments. In this article, we'll show you when it may be better to leave your assets exposed to the tax man when you're saving for retirement.

Types Of Investments
The first question most people ask, is "What types of investments should be placed inside tax-deferred accounts?" Because of their nature, tax-deferred accounts will provide the greatest benefit when they shelter investments that generate frequent cash flow, or distributions, that would otherwise be taxable, which allows these payments to remain whole and be reinvested most efficiently. Therefore, there are two types of investments in particular that are best suited for tax-deferred growth: taxable mutual funds and bonds. These two produce the most frequent taxable distributions, such as interest, dividends and capital gains.

Mutual funds distribute capital gains annually to all shareholders, regardless of whether those investors have actually liquidated any of their shares or not. Government and corporate bonds pay regular interest that is either fully - or at least federally - taxable, unless it is paid into a tax-deferred account of some sort. Of course, this is only an issue if the investor does not intend to draw upon the income generated from these investments. Taxable bonds and mutual funds may be a good idea for those who need to live on the income generated by these investments. Most interest and dividend income is usually taxed at the same rate as IRA and retirement-plan distributions, but in some cases it can actually be taxed at a lower rate.

Taxable Investments
There are several types of investments that can grow with reasonable efficiency even though they are taxable. In general, any investment or security that qualifies for capital gains treatment is a good candidate for a taxable savings account. This category includes individual equities, hard assets (such as real estate and precious metals), and certain types of mutual funds (such as exchange-traded funds and index funds). When capital gains rates decrease, taxable investments are more appealing for investors in certain situations, such as those who own long-term rental properties.

Stocks
Many real estate transactions can be structured as installment sales, thus allowing the seller to further defer capital gains and realize less income per year than is possible with a lump-sum settlement. Stocks, particularly stocks that pay little or nothing in the way of dividends, are better left to grow in a taxable account, as long as they are held for more than a year. Individual stocks that are held in a tax-deferred account can often be taxed at a higher rate than taxable stocks, because stock-sale proceeds that are taken as retirement-plan distributions are always taxed as ordinary income, regardless of their holding period.

Therefore, investors in all but the lowest tax bracket will usually pay less tax on the sale of taxable stock. The same is true for certain types of exchange-traded funds, such as Standard and Poor's Depository Receipts (SPDRs) which allow investors to invest directly in the S&P 500 index, and other index funds that do not pay dividend income of any kind. Utility stocks and preferred stocks are also held in retail accounts because the dividend income is often used by investors to pay monthly bills or other expenses. However, these stocks can be appropriate for tax-deferred investors seeking diversification as well.

Unit Investment Trusts
Unit investment trusts (UITs) can be useful taxable instruments, because when the trust resets at the end of its term, any stocks that have lost value can provide deductible capital losses when they are sold. However, investors that actually cash out of their UITs instead of allowing them to reset can conceivably face large capital gains distributions.

Ultimately, any type of investment that grows in value over time without distributing taxable income is probably better left in a taxable account, so that monies that are allocated to tax-deferred vehicles can be used for less tax-efficient instruments. As stated previously, this is especially true for investors who may need any income that is distributed to cover living expenses.

A Special Case: Annuities
Because annuities are inherently tax-deferred by nature, whether they should be used inside a retirement account or IRA has been the subject of much debate among financial professionals. However, they are ideal vehicles for high-income investors who are seeking to reduce their taxable investment income and have maxed out their other retirement savings options.

Conclusion
Although tax-deferred retirement accounts are very beneficial for millions of savers, it is unwise to assume that all types of investments should be shielded from taxation. Roth accounts may be an exception, as they shield your earnings from immediate taxation, and the earnings can even be tax-free if certain requirements are satisfied. A careful review of the current and possible future capital gains tax rates versus the tax that will be paid on retirement-plan distributions should be made to determine the best possible allocation of your retirement assets.

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