Tax deferral can sometimes be a costly mistake

Contrary to the common assumption, deferring taxes is not always a good idea. 

We caution against what many people routinely do: automatically opt for tax-deferred accounts. They usually do so because they assume their ordinary income tax rate will be lower after they retire. Or they think: “Even if my tax rate won’t be lower, it’s better to put it off for as long as possible.”

They can be wrong on both points.

People are often surprised to find they are still subject to top U.S. tax rates when they no longer draw a high salary but have significant assets. Also, and critically: Very few people realize that financial outcomes can be significantly different when you put pre-tax versus after-tax dollars into tax-deferred accounts. 

Yes, it’s usually a good move to put pre-tax dollars into tax-deferred accounts. So, if you can, it’s often wise to take advantage of any deferred compensation plans and make pre-tax contributions to traditional 401(k)s, up to the maximum allowed.¹

But the minute you are talking about after-tax dollars, we believe you should be careful (with, for example, your non-deductible contributions to IRAs and non-qualified annuities).² Choosing tax deferral for the wrong reasons—or with the wrong assets—could mean you wind up paying almost double the tax rate.

There’s no need for you to make costly mistakes. Here’s what you might do instead.

You may always be subject to the highest ordinary income tax rate

First, check: Do you know what your tax bracket will be in the future, after tallying your Social Security, required minimum distributions (RMDs) and other sources of taxable income? 

Many people don’t realize that—even after retirement—they could be subject to the highest tax brackets that today, at the federal level, are 35% and 37% (the latter for annual income of about $694,000 for a couple and $578,000 for an individual).

There are state and local taxes, too. And in the future, the top federal rate is scheduled to revert to 39.6% in 2026, when some provisions in the 2017 Tax Cuts and Jobs Act sunset.

For people with wealth, today’s top thresholds can be quickly met.

Say you have a $30 million portfolio that generates an annual yield of just 2%. That would produce $600,000 of income a year before any capital gains you might realize through rebalancing and prudent portfolio management.

Then assume Social Security (of about $45,000 per person) and required minimum distributions from you and your spouse’s $2 million IRAs (the most common sources of retirement income), and that’s another $250,000 in income for a married couple filing jointly with two retired workers.³

The result: You might no longer be drawing a salary, but you’d still be subject to the highest tax rates in effect today.

When to choose taxable accounts and pay as you go 

So let’s say you’ll be subject to the highest income tax rate in the future. The next things to understand are the tax implications of tax-deferred accounts. While taxes are deferred until the future, keep in mind:

• All withdrawals from tax-deferred accounts are taxed as ordinary income
• You can’t use the assets in tax-deferred accounts for tax-loss harvesting
• The assets in tax-deferred accounts don’t receive a step-up in cost basis at death

Given this, when could a taxable account make more sense? Answer: Much more often than most people assume when after-tax dollars are involved.

You may want to pay taxes as you go, keeping after-tax dollars in taxable accounts if:

• You can get preferential tax treatment on their return—i.e., you can pay the 23.8% tax rate for long-term-capital gains (LTCG) or qualified dividend income (QDI).⁴ This approach might be wise even if you expect that investment to have a high return, as long as the majority of that return is from LTCG or QDI (think S&P 500 exchange-traded funds or private equity)

• You want to harvest tax losses—i.e., you want to realize investment losses to offset your gains and reduce your annual tax burden (regular tax-loss harvesting can be particularly advantageous when markets are volatile)

• You want to leave those assets to family members—Assets in taxable accounts get a “reset” in cost basis at death, meaning that your heirs will not owe taxes on all of the appreciation you achieved since first acquiring the asset. The same is not the case for tax-deferred accounts, as human beneficiaries also inherit an embedded tax liability with those assets⁵
  

Making the right choice can make a sizable financial difference 

What happens when you put a so-called “tax-efficient investment” (one in which the return profile is predominantly from QDI and LTCG) into a tax-deferred account? Instead of paying 23.8% along the way, you’d pay nearly double in taxes on the funds—37%—when you finally make withdrawals.

How much would you then have to earn annually so that the amount you’d receive from the tax-deferred account would equal how much you’d get from the taxable account? A large—and largely unrealistic—rate of return would be essential. That’s true even in places where you would have to pay a higher rate (such as New York City).⁶

For a resident of Texas (where there are no state income taxes) to have the same value in hand after 20 years, the tax-efficient investment would have to earn 11.5% annually in the tax-deferred account.

When does it still make sense to opt for tax deferral?

There are five main reasons to put your after-tax dollars into tax-deferred accounts:

1. The investments are “tax-inefficient” (i.e., their return does not qualify for the 23.8% tax rate as LTCG or QDI)—Such investments could include high yield bonds, private credit, actively traded equity strategies that generate significant short-term capital gains, and some hedge funds.⁷

2. You want to trade without any immediate tax consequences—For example, say you had a $30 million portfolio, including a $3 million tax-deferred account. You could buy and sell investments in the tax-deferred account without having to recognize any gains. The goal could be to use this tax-deferred account, and the investments within, as a counterbalance for your broader portfolio (e.g., have all $3 million in stocks when valuations are cheap and then move to all fixed income when equity valuations become frothy). 

3. Your ordinary income tax rate will be significantly lower in the future—Even if your U.S. tax rate might remain high, your state taxes would be lower if you moved from a high-income-tax state like New York to a no-income-tax state like Florida.

4. You plan to convert a traditional IRA to a Roth IRA in the near future—Any after-tax contributions would not be subject to tax upon conversion, and once in a Roth IRA, any future growth pulled out through qualified distributions will be tax-free.⁸

5. The assets are earmarked for charity—As the charity won’t have to pay any taxes on these assets, there is no reason for you to do so.

We can help

Where to put which investments is obviously a complex question—but well worth considering carefully. Your J.P. Morgan team is available to work with you and your tax advisors to help you make sure your decisions truly support your long-term goals.

¹In 2023, the maximum amount of pre-tax dollars you can put into a 401(k) is $22,500. If you are over 50 years old, another $7,500 is allowed (so $30,000).

²If an individual is covered by an employer retirement plan, no deduction is allowed for a contribution to a traditional IRA if Modified Adjusted Gross Income (MAGI) is above modest thresholds ($83,000 for single or head of household taxpayer, and $136,000 for those married and filing jointly). 

³In 2023, maximum annual Social Security benefit at full retirement age is $43,524 annually and could be higher if an individual delays until age 70.

⁴Includes the 3.8% Medicare surtax on net investment income.

⁵In contrast, tax-deferred accounts always pass on an embedded tax liability in the form of “income in respect of a decedent” (i.e., the untaxed income that a decedent had earned or had a right to receive during their lifetime). IRD is taxed to the individual beneficiary or entity that inherits this income.

⁶This isn’t to say holding a tax-efficient investment in a tax-deferred account is always the wrong decision; however, there could be a more optimal location for it if you have taxable accounts in your portfolio. 

⁷Given that hedge funds are a broad asset class, the investor will need to review the strategy of the hedge fund to determine if the return generated would likely be treated as ordinary income via interest and short-term capital gains. If a hedge fund is classified as a 475(f) hedge fund, returns will generally be treated as ordinary income, and thus would be deemed tax-inefficient.

⁸Distributions from a Roth IRA are considered qualified distributions if you are 59½ or older, and the account is at least five years old. Qualified distributions are tax- and penalty-free.