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Deferring Taxes Until Retirement? You May Want to Rethink That

Conventional wisdom about putting money in qualified accounts (401(k), 403(b) and IRA are examples) for decades has been to defer your tax liability on those assets for as long as possible and get growth in those accounts unhindered by taxes. If you can wait and pay Uncle Sam later, why pay him now?

As the qualified accounts grow, so does the tax liability — along with the future pressure that required minimum distributions (RMDs) may cause related to where you end up in tax brackets and Medicare premium surcharges.

The reality is that if tax rates go up, deferring is not likely helpful and may actually be harmful. If you have a known tax liability today (that’s fairly low by historical standards), settling that liability is not always a bad idea.

The risk of deferring taxes well into the future is the uncertainty. Tax rates down the road are up in the air, but you can probably count on the word “up.” They are relatively low now, due to the Tax Cuts and Jobs Act of 2017, which expires at the end of 2025. Taxes can go up in the future in at least a few ways. (They can go down or stay the same also, but few believe that will happen.)

First, for many people, tax rates can increase starting in 2026 if Congress doesn’t extend the rules currently in place, and who knows how high they might go in subsequent years as many continue to retire? When Uncle Sam comes calling in your retirement (RMDs and Medicare premiums included), you’ll likely want more control and less tax burden whenever possible.

Second, many retirees may face tax increases for other reasons. Death of a spouse is one. Divorce can be another. Either circumstance can put a person into a single-tax-filing status whereas they previously filed jointly.

Further, taxes could also go up if Congress chooses to raise rates to address the spending that seems to continue to spiral.

Here are some other issues to consider.

Deferring capital gains in non-qualified accounts

Too many people, because they want to limit as much as possible the amount of tax they will pay in a given year, will not sell a stock that has appreciated significantly and will allow greater and greater concentration in an individual stock. That is an example of letting “the tax tail wag the dog.”

When it comes to investment returns, your focus should be on managing risk and thinking in terms of net gains after taxes and on limiting your taxes in retirement. Again, this is about considering settling a liability at a reasonable tax rate rather than at a rate that is likely to be higher in the future. Just like ordinary income tax rates can increase in the future, so, too, can capital gains tax rates.

‘Tax location’ of assets

Pay attention to tax location when looking at your investments. What does that mean? You do not have to have your qualified accounts (IRAs401(k)s) invested the same way as your non-qualified accounts (those that don’t receive “preferential” tax treatment).

Example: Let’s say I am retired and have $1 million in a traditional IRA and decide to withdraw $50,000 from that IRA. That withdrawal will be taxed as ordinary income, as is the case with all qualified accounts, no matter what I own in that account.

But with a non-qualified account, how the money is taxed depends on what kind of investment asset I own. For instance, if I own a corporate bond, and I receive interest income on that bond, that is going to be taxed as ordinary income. But if I own a stock, and its value has increased significantly, all of that appreciation is capital gain and, if held for greater than 365 days, is treated as a long-term capital gain and not ordinary income. And under current law, capital gains taxation is generally better for the taxpayer than ordinary income taxation.

So, consider owning things that generate ordinary income in accounts that, no matter what you own, are taxed as ordinary income, and own more capital-gain-oriented assets in accounts that can enjoy capital gains rates.

The long-term Roth advantage

It is beneficial to have assets that have the highest long-term growth potential in a Roth IRA. You don’t get to defer taxes on the money you deposit in a Roth, but you do get growth tax-free and withdrawals tax-free. You’re not going to be hit with taxes when you make withdrawals in retirement, which means you don’t have to worry about those future tax rates.

If you have a capital-gain-oriented asset (usually assets that have growth potential), such as a stock, the least advantageous thing you could do in terms of taxes is to invest in that stock through a qualified account. Again, that goes against conventional wisdom because everyone is told to defer, defer, defer, and you get to use the government’s money — until it is time to pay the piper later.

When you defer, all you are doing is expanding the liability. When you put $100,000 in a 401(k), you’ve deferred taxes on that $100,000, but if it grows to $500,000 over many years, wonderful, you’ve also got a tax liability on that $500,000 awaiting you. And if the tax rates are higher when you get to retirement, what you gained will be considerably less.

Having a short-term mentality is not prudent when it comes to investing, nor is it when it comes to taxes. It is not the person who pays the least amount of taxes this year who wins. It is the person who thinks long-term and limits their long-term tax liability — and has a more enjoyable retirement because they did so.

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