Putting Tax-Deferred Accounts to Best Use

Kathleen M. Fisher

Kathleen M. Fisher (pictured) and Tara Thompson Popernik

The common wisdom about retirement planning is to fund tax-deferred vehicles such as 401(k) plans and IRAs to the max—and we agree. But how to put these accounts to best use is more complicated.    

15%+ More After-Tax Wealth
Few dispute the virtues of compounding funds on a tax-deferred basis. We estimate that after two decades of growth, in the median case a tax-deferred portfolio will generate 15% more proceeds after federal taxes than a taxable counterpart, assuming that today’s tax regime remains in effect.

In fact, many investors are likely to gain more than an extra 15% from a tax-deterred account, since their tax rate in retirement will probably be lower than it was during their working years. They’ll do better still if, like many retirees, they move from a high-tax to a low-tax state.   

Spend First from Taxable Accounts
But there are ways to maximize the virtues of tax deferral. For example, investors approaching or already in retirement frequently want to know which account to spend from first—taxable or tax-exempt.

For investors who intend to leave tax-deferred assets to beneficiaries, this decision is complicated and must be coordinated with their estate plans. But for other investors, it almost always makes sense to extend tax-deferred growth for as long as possible. The general principle is to spend down your taxable portfolio first.

The display below shows the case of a 65-year-old couple with $1 million in an individual retirement account (IRA) and another $1 million in a taxable account. They have a moderate-risk asset allocation and spend 3% of their initial portfolio value each year, grown with inflation.

If they withdraw first from their taxable account and take only the required minimum distributions from their IRA starting at age 70½, we project that the couple’s assets will last 31 years in poor markets, rather than 29 if they spend from their tax-deferred account first. Two more years of spending will be very welcome if one or both spouses are lucky enough to reach age 94.  

A Question of Asset Location
Those who own both a taxable and a tax-deferred account often wonder which assets to hold in each. Our research indicates that location doesn’t matter much with respect to stocks and bonds. It would seem logical to fill your tax-deferred account with bonds, since the top marginal tax rate on bond income (including the 3.8% Medicare surtax)  is 43.4%, versus 23.8% for long-term capital gains and qualified dividends. However, but the bulk of returns in a balanced account is likely to come from stocks. The benefits of sheltering these assets tend to cancel each other out. This issue is best explored on a case-by-case basis by each investor and his or her advisors.

But some diversifying asset classes are better housed in a tax-deferred portfolio.  REITs, for example, pay out large dividends that are taxed as ordinary income. Hedge funds, which tend to trade frequently, may take short-term capital gains, which are taxed at the same rate as ordinary income. 

It’s wise for all investors in retirement to review the performance of their assets in their taxable and tax-deferred accounts, as well as their spending patterns and tax brackets. Any changes or concerns warrant a discussion with investment and tax professionals. 

Next in this retirement investing series: Spend less? Work more?

Bernstein does not offer tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

The Bernstein Wealth Forecasting SystemSM  uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

Kathleen M. Fisher is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein. Tara Thompson Popernik is the Group’s Director of Research.


  1. 1) The industry has taken to repeating the supposed “investors in retirement frequently want to know which account to spend from first—taxable or tax-exempt.”

    But all spending is done from taxable accounts. You cannot touch the assets in tax-exempt or tax-deferred accounts without first moving the assets to taxable accounts. (lets ignore buying annuities).

    The true question is “Should you pre-maturely move assets from retirement accounts to taxable accounts —- when you don”t actually need the $$ for spending?” (Obviously if you need the cash then there is no decision to be made).

    2) The idea that “their tax rate in retirement will probably be lower” is pure presumption. Personally I will be in a much higher rate. It all depends. There are a long list of factors that are completely unknown.

    Advice should not have presumptions built into it. It should tell people the different actions required by different presumptions.

    3) The author is correct is saying the highest benefits from retirement accounts is NOT determined by the tax rate. But he is incorrect to claim it makes no difference. She fails to clarify that it is a higher growth rate of the account (the rate of return) that generates higher benefits over time. (Assuming lower/equal tax rates of TDA”s withdrawals).

    It is not the tax rate. It is not the tax$ (tax rate times rate of return). It is the rate of return. See Rethinking Asset Location

    4) She fails to point out that when you assume a HIGHER tax rate on withdrawal from tax-deferred accounts, it is probable that the advice is reversed – you want LOW growth rate assets in the shelter.

    • Tara Thompson Popernik

      Thanks for your comments.
      Point 1 is technically fair. Before it can be spent, the retirement distribution must either be made to an investment portfolio or a cash spending account (such as a checking account), both of which are taxable. The industry answers the question this way because it’s the way clients ask it.
      2. Yes, it all depends. In certain specific cases, a retiree’s effective tax rate may be higher. Typically, however, under current US tax law, a high-earning US taxpayer’s rate will be higher during his/her working years than his/her retirement years. The reason is the steepness of the US tax rate curve. For example, up to the first $17,850 is taxed at just 10% for joint filers and the top marginal federal rate of 39.6% doesn’t start until over $400,000 of taxable income for an individual or $450,000 of taxable income for a couple.
      3 and 4: Your point isn”t clear.

  2. Victoria McInerney

    Hi Kathleen,
    I very much enjoy your investing comments–very succinct, which I appreciate.
    Thank you.

  3. The impact of RMDs is understated in this article. For those who save heavily in tax-deferred accounts with appreciable rates of return, and given that RMDs are intended to effect a complete withdrawal over normal life expectancy, there is the real risk that excessive withdrawals will need to be made that force the participant into needlessly higher tax brackets; the assumption that retirees will be in lower tax brackets makes assumptions around the change in earned income versus retirement income, which is overstated, due to the tax deferral of earned income saved in retirement plans, and the withdrawals from these plans needed to support a lifestyle that substitutes new expenses for old at a similar level. There ought to be a balance over time between tax-deferred assets and tax-free (Roth treatment) assets, to ensure a smooth taxation of assets at a reasonable rate over the financial lifecycle; tax-deferred assets are intended to be taxed eventually, and there needs to be balance.

    • Tara Thompson Popernik

      We fully agree with your point about balancing between Roth and traditional IRA accounts. For individuals who won’t use their RMDs for spending, a Roth conversion is a good way to allow assets to grow in a tax-free environment.

      RMDs for account owners won’t deplete accounts completely over a normal life expectancy. The RMD starts at 3.65% of the value of the account at age 70.5 and increases annually. A 70-year-old man is expected to live to age 86, when he would need to take just over 7%. At those rates, he””s unlikely to deplete the account in 16 years.

      As for the tax rates, our research on benefits of tax deferral was done assuming a the same rate during working years and retirement, many individuals will see their rates decline in retirement. One big reason is state tax rates: of 41 states with income taxes, 37 states provide some exemption for retirement income either exempting Social Security or allowing all or a portion of IRA withdrawals to be made free of taxes at the state level.

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