Why Tax-Deferred Accounts Can Present Problems When You Retire

Lower Your Tax Bill by Creating Balance

A young woman sitting on the floor with a laptop and paperwork checking her 401k.

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Socking away all your money into tax-deferred plans such as 401(k)s, 403(b)s, 457 plans, and individual retirement accounts (IRAs) can be good until you create a situation in which all your financial assets are inside tax-deferred accounts. This can cause problems once you're retired because of the way retirement income is taxed.

Key Takeaways

  • The funds you withdraw from tax-deferred accounts are taxed as ordinary income.
  • Depending on the amount you withdraw, up to 85% of your Social Security benefits could be taxed as well.
  • Using a blend of after-tax and pre-tax accounts can give you more flexibility in retirement, as you can make withdrawals from your after-tax accounts tax-free.
  • Choosing where you place your different types of investments is called asset location, and it can help you further optimize your tax situation.

Taxes on Withdrawals Matter

When you withdraw money from tax-deferred accounts, it will be taxed as ordinary income in the calendar year in which you make the withdrawal. If you need extra funds for a vacation, a new car, or to help a family member, the excess funds withdrawn may bump you into a higher tax bracket. For example, a taxpayer who files single returns can withdraw up to $10,275 in the 2022 tax year and remain in the 10% tax bracket. After that threshold, withdrawals will start being taxed at 12% until the next threshold is hit at $41,775.


Withdrawals only count toward taxable income when you're withdrawing from a tax-deferred account. Withdrawals from after-tax accounts, such as Roth IRAs, aren't taxed.

Withdrawals Affect Social Security Taxation

In addition to considering how withdrawals will affect your tax bracket, you'll also need to be aware of how withdrawals can affect how your Social Security income is taxed. Too many withdrawals may make more of your Social Security income subject to taxation.

A formula determines how much of your Social Security is taxed. One of the components of this formula is the amount of "other income" you have. Additional IRA withdrawals increase the amount of other income and may cause more of your Social Security income to be taxed.

Social Security Taxable Income = Adjusted Gross Income (AGI) + Nontaxable Interest + 1/2 Social Security Benefits


Depending on the amount of your other income, you either pay taxes on 50% of your Social Security income or 85% of your Social Security income. By carefully planning the way you withdraw from retirement accounts, you may be able to lower the tax consequence by saving in a tax-smart way.

Building Diverse Tax Buckets Can Lower Your Lifetime Tax Bill

Rather than putting all your money into tax-deferred accounts, build up both after-tax and tax-deferred accounts. Work with a certified public accountant (CPA) or retirement income planner to estimate your tax bracket in retirement. If it will be about the same or higher than it is now, consider funding Roth accounts instead of tax-deductible IRAs and making Roth contributions to your 401(k) or 403(b) plan (if the plan allows this).

As you near retirement, it will be important to have a balance of after-tax and pre-tax money. Even if you are foregoing some deductions now, by planning ahead, you will be creating financial flexibility that may be useful once you are retired.

Use Asset Location Strategies To Save Even More

As you build up tax-deferred and after-tax accounts, you can use asset location strategies to make your plan even more tax-friendly.

Asset location is the process of strategically choosing where to place your assets for maximum efficiency. For instance, you'd place your high turnover, high income-generating assets inside tax-deferred accounts. Then you'd place low turnover investments that generate qualified dividend and long-term capital gains in your non-retirement accounts (the ones that send you a 1099 form each year).


Investments such as taxable bonds (which generate interest income) and small-cap stock funds (which typically have high turnover and generate more short-term gains) can be placed in tax-deferred accounts. You'll pay no tax with these accounts until you withdraw funds, regardless of the underlying investment income activity.

Tax-efficient holdings such as tax-managed funds, large-cap stock funds, and dividend income funds can be located in your non-retirement accounts, where you can take advantage of the lower tax rate that applies to qualified dividends and long-term capital gains.

If these same holdings are owned inside your retirement accounts, the qualified dividends and long-term gains will end up being taxed at the higher ordinary income tax rate. That's because all withdrawals from tax-deferred retirement accounts are reported as ordinary taxable income. Because of this, the withdrawal will not retain the underlying character of the income, such as dividend or capital gain, and won't benefit from that lower tax rate.

The Bottom Line

Taxes matter. By creating a balance of tax-deferred and after-tax investment accounts, and locating investment holdings inside these accounts in a tax-efficient way, you can save multiple thousands in taxes over your investing lifetime.

Frequently Asked Questions (FAQs)

Why do many experts recommend tax-deferred accounts such as a 401(k)?

With tax-deferred accounts, your investments can grow without tax implications until a future time when you withdraw the funds. It's especially beneficial for those who expect to be in a lower tax bracket at retirement because your withdrawals are taxed as regular income. You could pay less in taxes then than you would if you withdrew the funds now.

What are some other options for investing in addition to your 401(k)?

In addition to your tax-deferred accounts, such as your 401(k), you can place some of your investments in after-tax accounts such as a Roth IRA (if your income level permits it) or make after-tax contributions to your retirement plan, if allowed. Another option is to choose which investments you place in your tax-deferred accounts and place others, such as ones that produce qualified dividends, in your regular taxable accounts. There, your gains will be taxed at the capital gains rate instead.

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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

  2. Social Security Administration. "Benefits Planner."

  3. Social Security Administration. "Income Taxes and Your Social Security Benefit."

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