Not All Retirement Accounts Should Be Tax-Sheltered

Some tax-sheltered accounts can end up costing you more in taxes

Fact checked by Yarilet Perez
Reviewed by David Kindness

Millions of Americans sock money away every year in individual retirement accounts (IRAs), annuities, and traditional, employer-sponsored retirement plans. The tax deferral that these plans and accounts provide can amount to significant savings, as long as your tax bracket in retirement is less than your tax bracket when you contributed to the plan. Roth IRAs and Roth 401(k)s, on the other hand, offer no upfront tax break, but there are tax-free withdrawals, as long as certain conditions are met.

However, there are times when the taxes you’ll owe on retirement-plan distributions can be greater than the tax you’d have to pay on un-sheltered, taxable investments. In this article, we’ll explore when it may be better to leave your assets un-sheltered as you’re saving for retirement.

Key Takeaways

• You can save for retirement in both regular taxable accounts and tax-sheltered retirement accounts.
• Investments that generate a lot of taxable income are best for tax-sheltered accounts.
• Investments that don’t produce much taxable income but that are likely to grow in value can be better in regular, taxable accounts.
• In some cases, your tax bill will be lower on withdrawals from taxable rather than tax-sheltered accounts.

When Tax-Sheltered Accounts Make Sense

The first question most people ask is, “What types of investments should I put in tax-sheltered accounts?” The answer is that tax-sheltered accounts provide the greatest benefit when they hold investments that generate frequent cash flow, or distributions, that would otherwise be taxable each year. A tax shelter allows those payments to remain whole and continue to compound. (With a traditional account, the tax bill will come later, when you begin to make withdrawals.)

Two types of investments that are particularly well-suited for tax-sheltered growth are taxable mutual funds and bonds. They produce the largest and most frequent taxable distributions, such as interest, dividends, and capital gains distributions.

By law, mutual funds must distribute their capital gains annually to all shareholders, and unless a fund is held in a tax-sheltered account, the distributions are considered taxable income for that year. That’s regardless of whether the investor takes the distributions in cash or simply reinvests them in more shares. Similarly, government and corporate bonds pay regular interest that is taxable, unless they’re held in a tax-sheltered account of some type.

When Taxable Accounts May Make More Sense

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 at tax time is a good candidate for a taxable account. That’s because capital gains are currently subject to a lower tax rate than retirement plan distributions, which are taxed at the same rate as your regular income.

This category includes individual stocks, hard assets (such as real estate and precious metals), and certain kinds of mutual funds (such as exchange traded funds and index funds, which typically generate smaller taxable distributions each year than other types).

Important

As an added benefit, investments held outside of retirement accounts are not subject to early withdrawal penalties or required minimum distributions. You can take out money whenever you please—or never take it out at all.

Individual Stocks

Stocks, particularly those that pay little or no dividends, might be better left to grow in a taxable account, as long as you hold them for more than a year. Stocks held less than a year before they’re sold are subject to the higher tax rates on short-term capital gains, currently the same rates that apply to your ordinary income.

However, if you hold individual stocks in a retirement account, the proceeds you receive when you sell them will be taxed as ordinary income, regardless of their holding period.

As a result, investors in all but the lowest tax bracket will usually pay less tax on the sale of stock held outside of their retirement accounts.

Annuities and Municipal Bonds

Because annuities are already tax-sheltered by design, there is no added financial advantage to owning them within a tax-sheltered retirement account. The same is true of municipal bonds and municipal bond funds, which are generally not subject to local, state, or federal taxes.

If You Have an Excess to Invest

If you’re fortunate enough to have a great deal of money to invest for retirement in any particular year, you could find that it exceeds the limits for retirement accounts.

For 2025, for example, your traditional and Roth IRA contributions can’t exceed $7,000 in total (or $8,000 if you’re 50 or older). For 2024, the contribution limit was also $7,000 (or $8,000 for those age 50 and older).

In the case of 401(k) plans, your contributions can’t exceed $23,500 for 2025 (or $31,000 if you’re 50 or older). For 2024, the limit was $23,000 (or $30,500 for those age 50 and older).

One strategy is to max out your tax-sheltered accounts first and then put the rest into regular taxable accounts. The same basic investing principles described above will apply, with retirement accounts being best for the kinds of investments that generate a lot of otherwise taxable income each year.

What Is the Difference Between a Traditional IRA and a Roth IRA?

The major difference between a traditional IRA and a Roth IRA—as well as between a traditional 401(k) and a Roth 401(k) account—is when you receive a tax break. With a traditional account, you can get a tax break when you contribute, but your withdrawals will be taxed. With a Roth account, you don’t get an upfront tax break but your withdrawals will be tax-free if you meet certain IRS rules. With either type of account, your money grows tax-sheltered in the meantime.

After I Retire, Should I Take Money from My Retirement or Regular Accounts First?

Financial planners generally recommend that you take money from regular accounts before retirement accounts in order to preserve the tax-sheltered status of the latter for as long as possible. Note, however, that after age 72 you must begin to take required minimum distributions (RMDs) from any traditional (non-Roth) retirement accounts.

How Do I Determine My Required Minimum Distributions?

Your required minimum distributions (RMDs) are based on your retirement account balances and your age/life expectancy for that particular year. The IRS provides further information and worksheets for calculating your RMDs in Publication 590-B Distributions From Individual Retirement Arrangements (IRAs).

The Bottom Line

Tax-sheltered retirement accounts aren’t the only—or even the best—way to save for retirement. Tax-sheltered accounts make the most sense for investments that spin off a lot of income that would otherwise be taxable in the year you receive it. Investments that you expect to grow in value over time—but won’t produce much taxable income—may be better left in an ordinary, taxable account. You’ll have greater access to the money if you need it before retirement, and you may ultimately pay less tax on it when you make withdrawals.