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Pay a Little Now or a Lot Later

Your Worst Accounts for Taxes While Working May Be Your Best in Retirement 

By Michael Lynch CFP®

I’m gonna tell you something few others will. It’ll cost you a bit today, perhaps, but like a habit of taking regular trips to the gym in your 30s and 40s, it’ll pay off big in your 60s and beyond.

Here goes: Open and fund an account, ideally based on well-managed equity mutual funds, that will give you an annual tax bill.

Get annoyed each year when that 1099-Div tax form forces you to pay taxes on reinvested dividends and distributed capital gains that you didn’t need.

You’ll likely never sell an investment to pay the tax.

This will set you free to spend big in retirement.

Okay, Not Really Advice for You

This of course isn’t advice specific to you. I don’t know you. It’s not good for everyone, just millions of Americans. Stick with me to determine if you’re one of them.

This strategy of taking a steady stream of predictably manageable pain may help you avoid a worse fate in the future. It’s not unlike those strategies employed by nervous and realistic aristocracy back in the day. Recall from your high school learning how nervous royalty, with lots of jealous enemies, perhaps even a spouse who wanted all the money and none of the wife or husband, would regularly ingest small doses of the preferred poisons to build up immunity.  When the terrible day came, they’d survive and be able to go about their business.

So too is it with income taxes and the business of retirement.

In retirement, this business is likely to be fun trips, new cars, and other things that require substantial, non-budgeted cash outlays. And you can be certain that someone will try to poison you: your Uncle Sam with taxes on your IRAs and other pre-tax retirement plans.

The Courtiers Often Mislead

Full disclosure: I’m approaching 55 and I’ve been intensely interested in personal finance since my early 20s. My earliest memories up through today focus on tax deferral and tax savings, stressed both in the personal financial press and by representatives of companies offering products that provide tax deferral. (We all know that the insurance industry makes a huge deal about the tax benefits of tax-deferred, non-qualified annuities and cash value life insurance.)

The basic approach recommended involves some variation of accumulating a cash reserve and then contributing the maximum to pre-tax retirement accounts, and then filling up Roth IRA or tax-favorable insurance-based products prior to investing in taxable accounts. The latter are often presented as problematic because of the annual tax bill they foist on us.

Therefore, the standard advice goes, if you must use taxable accounts--and many middle-class Americans don’t need to, since retirement plan limits are high--use tax-efficient exchange traded funds (ETFs) to avoid annual tax hits. These tend to preserve the original cost basis and don’t pass along annual capital gains distributions.

I’m not saying this advice is always wrong. If you’re in the top tax brackets today and expect at least a one-tick step down in retirement, fill up the pre-tax accounts. But if you’re in the top tax brackets, you’ll need to invest more than these accounts allow anyway, so chances are that you’re already using non-qualified accounts.

And there’s certainly a role for low-taxed basis accounts for many who are not in the top brackets. These are great tools for some tasks. It’s just not providing you with tax-free income.

Die with them and, under current law, you’ll avoid paying on the gains, and not just because you’re gone. They’ll “step up in basis,” meaning the price of the securities on the day you pass becomes the new tax basis. You can’t spend it tax-free, but your heirs can.

If you want to avoid the tax while alive, low-basis stock and ETFs are fantastic assets to donate to charities, which can sell even the most appreciated securities without incurring a tax.

Don’t Get Stuck in the Middle

My focus here is on the middle-class millionaires. You know who you are. You live on modest amounts of money each year but have accumulated substantial retirement accounts. The biggest frustration I see my middle-class millionaire financial planning clients experiencing is not having too few funds in retirement accounts. Far from it: they become frustrated by having too much money parked there.

In other words, you’re constantly told that you may run out of money when in fact you’re far more likely to be an involuntary generous funder of the U.S. government.

Sure, your pre-tax retirement accounts provided pleasure on the way in, but that was then and this is now.  On the way out it’s all income tax pain, combined with other indignities like being forced to pay more for Medicare Parts B and D.

The solution, it turns out, is a properly sized, good old-fashioned non-qualified investment account filled with mutual funds that dish out income, dividends, and capital gains distributions each year. You’ll pay some extra tax each year, which is a cost for sure. But the benefit is that every dollar of taxable distribution, of which you pay only a fraction in taxes, increases your taxable cost basis by a dollar. When it comes time to use the money—such as spending it on fun things like vacations for the entire family or cash purchases of cars and trucks--it’ll come out practically tax-free.

The $64,000 Car

Let me put this in perspective. Let’s say you want to withdraw $50,000 from an account for a one-time expense, an example I recently had with a client. The purchase could be a new car or perhaps a beach house vacation for the extended family.

If this money must come from an IRA or other pre-tax retirement plan, you’ll have to take out just over $64,000 to spend the $50K. That’s only for the feds and assumes you’re lucky enough to stay in the 22 percent tax bracket and it does not increase, as scheduled under current law, to 25 percent in 2026.

Alternatively, if the money is in a bank account, it’s dollar for dollar. You take out $50,000 to spend the $50,000. The problem here is that until just recently, there was no growth for 20 years. So, you will be spending depreciated dollars.

If you could take this money from an account that had doubled in value and in which 90 percent of gains came from annual distributions, you would likely pay, at most, just 15 percent capital gains tax on this gain and nothing on your contribution. In this example, that would be roughly $378 in tax.

That’s right. Your tax as a percent of the money out of your account is less than 1 percent! This is Roth-like treatment on the way out and you’re smiling all the way to the dealership or travel agent.

Speaking of Roths, you probably have Roth IRAs available to you, either by direct or back-door contributions, and should likely use them aggressively. (I say probably and likely because, well, I don’t know you.) But there’s only so much you can contribute to these accounts. If you have an employer plan, the limits are now high.  But this does not apply to everyone.

What About Low Tax Basis?

So, we’re back to taxable investment accounts. With the rise of ETFs in the last 20 years, investment advisors like me have been busy building tax-efficient accounts. This involves minimizing capital gains distributions and sometimes even dividends so that year to year the tax bill is minimal.

This keeps the cost basis low, however, so the more you win with the investment the more you’ll lose to taxes when you sell it.

In other words, the more gains you have here, the more these accounts resemble IRAs, for which people have a natural aversion to using the money.

Cure the Parking Disease

I call it the parking disease, a term I developed living in San Francisco’s Mission District in my twenties. The trap is simple. You get a car to be free and do such things as shop more efficiently, visit friends, and leave town on long weekends. The problem is that you can’t use it.  Street parking spots are few and far between and garages don’t exist, aren’t convenient, or are unaffordable. Therefore, once you secure a free parking spot, you don’t dare use the car as you fear you’ll have no place to put in upon your return home.

In my San Francisco days, I solved this by using my motorcycle to save my spot until I returned. With taxes and investments, the solution is the old-fashioned mutual funds that are forced to distribute dividends and gains each year.

Pay as You Go May Be the Way to Go

Two things may both be true. You can hate something today and love it tomorrow. That’s the case with taxable accounts.

I also know that although having 100 percent of the best thing is ideal—like, let’s say, owning only seven stocks in 2023—it’s an impossible goal. The next best thing is to be allocated across a range of options, some of which will always be suboptimal at any given time.

When it comes to investing for personal finance, this is true for asset classes, the individual securities in these classes, and the accounts in which these asset classes and securities are held.

Although I don’t love rules of thumb, they are often better than conventional wisdom, at least if they are a bit counterintuitive and heterodox. So, here’s a structure to examine and determine whether it’s a fit for you.

  • Fill your cash reserve to avoid any credit card interest ever.

  • Fund pre-tax accounts at levels that, when combined with Social Security and any expected pension, will provide for a base of income at retirement that at least fills most of the 12 percent tax bracket.

  • Fund Roth IRAs and perhaps even Roth 401ks and after-tax Roth conversions, Mega-Back Door Roths, in employer plans.

  • Fund taxable investment accounts with a split between tax-efficient ETFs, for use with charitable giving and estate planning, and tax-inefficient mutual funds.

The latter will prevent a potentially debilitating case of the parking disease in retirement. After all, what good is even the safest and most comfortable car if you won’t drive it?


Michael Lynch CFP is a financial planner with the Barnum Financial Group in Ft Myers, FL, where he focuses on his clients’ finances so they can focus on their lives. He teaches consumer-oriented financial planning courses for leading organizations, including Madison Square Garden and Yale New Haven Health Systems. He is a member of Ed Slott’s Elite IRA Advisor Group and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020, and It’s All About the Income: A Simple System For a Big Retirement, May 2022. You can find more articles and videos at He can be reached at or 203-513-6032.

Michael Lynch is a registered representative of and offers securities and investment advisory services through MML Investors Services, LLC. Member SIPC. [link to on electronic advertisements] [6 Corporate Drive, Shelton, CT 06484 Tel: 203-513-6000

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. CRN202704-6369455