Summary/TL;DR
The tax-treatment of distributions from various investment accounts (IRAs/401ks, Roths, brokerage accounts, etc) are vastly different. If one does not plan on how they will unwind all their investments in conjunction with current tax laws, they will find themselves paying far more in taxes than is necessary. An effective distribution plan can not only save one taxes on their retirement accounts, but oftentimes on social security as well. When done properly, this type of planning can easily produce a tax-savings-sum that approaches or exceeds six-figures throughout one’s life.
Introduction
You’ve saved so much in “this account” and so much in “that account” and, when you retire, you’ll face the daunting task of figuring out how to unwind it all. But questions loom:
“What consequences do I face for taking from one account over another?”
“Are there advantages to leaving funds in this account over that one?”
“Should I move funds from one account to another? Am I even allowed to do that?”
“How will my distributions now impact me down the road?”.
What I seek to arm readers of this post with is an understanding of the different types of accounts they might be distributing from and how these distributions impact their taxes.
The Different Types of Accounts and How They Are Taxed
Pre-tax (Traditional) IRAs/401(k)s
If you are retired, I would be willing to bet that most of your investment portfolio is in a so-called “pre-tax” account. This would include Traditional IRAs as well as almost any employer retirement account that doesn’t have the word “Roth” in front of it.
Pre-tax accounts get their name from the fact that funds saved into them are not taxed at the time they are saved. In other words, they are saved before (“pre”) taxation. These funds remain untaxed until they are distributed in retirement. Distributions from these accounts become mandatory at age 73-75, depending on your birth year. These mandatory distributions are called Required Minimum Distributions, or RMDs.
Roth IRAs/401(k)s
Roth accounts are just the reverse of “pre-tax” accounts. When funds are deposited into a Roth account, they will still be included in your taxable income. However, Roth accounts remain tax-free forever after your original contributions (growth and all) as long as you follow a few IRS rules.
Non-Qualified Accounts
These accounts get their name from the fact that they are, simply, not “qualified” accounts like the ones discussed above. A qualified account is generally any investment account that qualifies for a tax-advantage contingent on certain rules being followed. A non-qualified account, then, is an account that does not qualify for any tax breaks, but also has the advantage of having no strings attached. Non-qualified accounts are also referred to as “taxable” accounts.
When funds are saved into a non-qualified account, they will still be included in your taxable income. When funds are sold (not necessarily distributed) only the growth is taxable. If funds are sold at a loss, this may reduce your taxes. Generally, if you’ve held the stock for less than a year, the gain will be taxed at your ordinary income rate (usually 12% or higher). If, however, the stock is held for a year or longer, then the gain will either be completely tax-free or taxed at a flat rate of 15% or 20% depending on your overall taxable income.
The Crux of the Issue – Tax Planning
As is made clear from the section above, the taxable nature of any distribution is wildly different depending on the type of account that the distribution is taken from. Distributions taken carelessly or excessively from a Traditional IRA will result in more of your savings going to the IRS than is necessary. Conversely, taking solely from your Roth or taxable accounts can result in higher than necessary Required Minimum Distributions later in life, again resulting in more taxes.
A plan that addresses the order and magnitude of distributions from your various accounts will save you tens- if not hundreds-of-thousands in taxes throughout your life. In fact, if you pay close attention to the amounts you are distributing from each account, you can control your taxable income and, therefore, your tax liability. This is all-the-more-so the case when you are taking social security, which is subject to its own unique tax rules. Social security can be an extremely tax-advantaged source of income with the right distribution strategy. Many, however, will fall victim to the so-called “social security tax torpedo”, which eliminates most of the tax-advantaged nature of social security. This is such an important concept that I’ll write a post dedicated to it in the future, but for now just know that the extent to which your social security is taxable varies widely.
3 Scenarios Illustrating the Importance of A Distribution Strategy
Let’s conclude by looking at these concepts in practice. We’ll examine three different scenarios for a retiree distributing funds from their various accounts. All three will produce the same amount of after-tax income but will result in a very different tax liability.
Scenario 1 – No Planning
In 2023, if you and your spouse distributed $50,000 from your Traditional IRA and received a combined social security benefit of $34,000, your federal income tax liability for the year would be $4,940 with 75% of your social security being taxable.
Scenario 2 – Introducing a Roth IRA
If you instead took only $35,500 from Traditional IRAs and $11,360 from Roth IRAs, your tax bill would shrink to $1,800 with 39% of your social security being taxable.
Scenario 3 – Delaying Social Security + Roth IRA
If you delayed social security benefits until age 70, you would only need $27,500 from your Traditional IRA and $10,070 from your Roth to receive the same net income, but your tax bill for the year would only be $670 with only 23% of your social security being taxed!
Now, imagine that these tax savings were realized every year for a thirty-year retirement – holy cow! In our simple examples, this is easily a six-figure sum that stays in your portfolio to grow, grant you additional security, and help you work towards your goals.
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