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.

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.

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.

Related Articles
  1. Budgeting

    Managing Income During Retirement

    Learn some sensible strategies for making your hard-earned savings last for as long as you need them.
  2. Retirement

    Will Your Retirement Income Be Enough?

    Find out how to determine whether you're on the path to a comfortable retirement, or financial ruin.
  3. Taxes

    Tips For Moving Retirement Plan Assets

    Moving assets is common when changing jobs or retiring, but you have to do this carefully to avoid penalties.
  4. Professionals

    How to Navigate Taxable Mutual Fund Distributions

    It's almost time for year-end capital gains distributions for mutual funds. Here's how to monitor them and minimize their tax impact.
  5. Retirement

    What Does It Cost to Retire in Panama?

    Learn how much it costs to retire comfortably in Panama, and why it has become one of the most popular retirement destinations in the world.
  6. Investing

    Baby Boomer Philanthropy Shifts Wealth Adviser Focus

    Wealth advisers who integrate philanthropy and finance planning can stand out with baby boomer clients.
  7. Retirement

    The 5 Best Retirement Communities in Dallas, Texas

    Discover why the Dallas/Fort Worth area of Texas is a popular retirement destination, and five of the best retirement communities in the area.
  8. Taxes

    The Top 10 Caribbean Tax Havens

    Discover relevant tax policy information about the top 10 tax havens located in the Caribbean, including the Cayman Islands and the Bahamas.
  9. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  10. Professionals

    How to Protect Retirement and Help Adult Kids

    Parents can both protect their retirement money and help their adult kids. Here's how.
  1. Should I use a deferred tax asset for all of my retirement funds?

    Tax-deferred retirement saving vehicles, such as traditional IRAs, 401(k) plans and annuities, are attractive to savers who ... Read Full Answer >>
  2. Are Cafeteria plans taxable?

    Whether the benefits you receive through your employer-sponsored cafeteria plan are taxable depends entirely on which benefits ... Read Full Answer >>
  3. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  4. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  5. Why is Luxembourg considered a tax haven?

    Luxembourg has been the tax haven of choice for many corporations and mega-rich individuals around the world since the 197 ... Read Full Answer >>
  6. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!