Flexibility is an often overlooked aspect of retirement funding. Specifically, flexibility in the tax impact of how you derive the cash flow needed to meet your expenses. While it may not be feasible in everyone’s situation, having diversity in the tax standing of your savings is arguably the optimal state for retirement savers. It can help you stretch your retirement dollars, as we’ll explain. A key first step is knowing how the various forms of savings vehicles will be taxed when you withdraw.
Account types are key. There are three broad categories, which will go a long way in determining the tax impact of withdrawals during your retirement: taxable, tax deferred and tax exempt.
Taxable accounts are investment or savings accounts that receive no special tax treatment, though they are not exclusively for retirement. They can be held in your name individually, joint names with your spouse, a business name, custodial accounts for children or other names. Many savvy retirement investors include taxable accounts in their retirement-funding plan.
There are no tax benefits for contributing to these type of retirement accounts, and there are no penalties for withdrawal itself at any age. Contributing to or withdrawing from a taxable account is identical to a passbook savings account at your local bank.
That said, investment activity in retirement accounts that fall in this category might incur taxes, depending on the specific types of transactions. For example, if you own a dividend-paying stock, you’ll pay dividend taxes and, potentially, capital-gains taxes if it rises and you sell. Bond owners typically pay taxes on the interest received and potentially other taxes on things like capital gains. However, capital gains, dividends and certain forms of bond interest are frequently taxed at more favorable rates than income, so this isn’t necessarily a huge negative.
In taxable accounts, an investor can “harvest losses” to offset gains. If you sell a security at a loss in a taxable account, the amount of the loss from your retirement portfolio can mitigate your tax bill. You are allowed by law to offset gains with losses dollar for dollar or deduct up to $3,000 in losses from your income. If you have more in losses than gains and exhaust this deduction cap, you can hold onto losses for use in future years (a loss carry-forward, in investment jargon).
Accounts that defer taxes until funds are withdrawn are generally focused on retirement (there are education versions as well, a topic for another day). These are Traditional Individual Retirement Accounts (IRAs) or workplace retirement plans like 401(k)s, 403(b)s and 457s.
Funds contributed to these retirement plans are frequently tax deductible.i Withdrawing from these accounts is almost always a taxable event—at ordinary income-tax rates. Withdrawals taken before age 59 ½ are also potentially subject to an additional penalty.
The benefits aren’t limited to deduction. Investment results aren’t taxed. No capital-gains, dividend or interest taxes mean more of your retirement money will grow over time rather than having to pay Uncle Sam a slice every year. Only funds removed from the account are taxed. For the same reason, losses cannot be claimed. Now, in exchange for these benefits, the IRS mandates you start withdrawing money in the year you turn 70 ½. Called Required Minimum Distributions, these withdrawals are based on your retirement account’s value and your age, and you will need to pay taxes on them.
Tax-exempt accounts are also generally retirement-focused (there are education versions here, too). These are Roth Individual Retirement Accounts (IRAs).ii Roth workplace retirement plans like 401(k)s, 403(b)s and 457s are less common, but growing in popularity for those that expect to see higher marginal taxes in retirement.
Unlike tax-deferred accounts, contributions to Roth plans are never tax-deductible. This is after-tax money you are investing, and it does not reduce your income subject to tax.
The benefits here are all about the investment results, and it is simple: There is no tax on withdrawals from these retirement accounts after age 59 ½. None. All the growth, dividends and interest are yours tax-free. That is a gigantic benefit. What’s more, there are no required minimum distributions from Roths.
The combination of the three tax statuses can give investors great flexibility in managing the tax impact of their retirement income. If all your assets are in traditional IRAs or pensions, your retirement cash flow will be taxed. But if you have taxable accounts and Roths, you can determine how much taxable cash flow you wish to draw. This can mean that a dollar in gross retirement cash flow is greater than a dollar in gross pre-retirement income! After all, an individual in the top federal tax bracket will take home about 60 cents on the dollar earned presently, assuming no state taxes. But diversity in tax status for your retirement accounts can mean you’ll take home a far greater share of the funds you withdraw to fund needs. This is an important determination when you consider how much income you’ll need to fund your glorious retirement.
iSubject to exclusion for higher earners.
iiThese are named for the late Sen. William Roth (R-DE), whose legislation added this option to the tax code. Thanks, Sen. Roth!