Understandably so, tax consequences of investment accounts can be difficult to understand for the untrained eye. Brokerage, retirement, taxable, tax-deferred, tax-free – these terms can make it tricky to know what may be best for your needs and which accounts you should be withdrawing from for maximum tax efficiency.
The order in which you withdraw money from different accounts can have a significant impact on how much tax you may pay over the course of your retirement, so proper planning can seriously help you in making sure Uncle Sam doesn’t get more than his fair share of your hard-earned retirement funds. This blog will guide you in understanding the basics of these accounts and withdrawal strategies that may fit your financial needs in retirement.
A tax efficient withdrawal strategy is basically a plan for deciding which investment or retirement accounts you should withdraw money from to pay less taxes. Ordinary brokerage accounts are not tax-advantaged retirement accounts, and any of the gains that you have on your investments within them are going to be subject to long-term or short-term capital gains at the federal level.
Long-term capital gains rates will be taxed at up to 20%, where short-term will be taxed as ordinary income – upwards of 37%, depending upon your tax bracket. Tax-deferred accounts such as traditional IRAs and 401(k)s will be taxed on the entire amounts withdrawn as ordinary income. Tax-free retirement accounts, such as Roth 401(k) and Roth IRAs are an advisor-favorite because the growth is nontaxable and qualified withdrawals are tax-free.
Advice given on how to withdraw from your brokerage or retirement accounts is going to vary person-to-person, but we can go over what may be a typical strategy for taking withdrawals from your retirement and brokerage accounts. One may take from taxable accounts first, due to the tax-advantages of most retirement accounts. The interest and dividends from taxable accounts is a current year taxable expense, where retirement accounts do not have such a condition.
Tax-deferred accounts would ideally be distributed next, and you would pay ordinary income tax on these. Chances are, these had decades to grow tax-deferred. The last accounts that should face withdrawal are the tax-free accounts. Due to the nature of tax-free compounding interest, these are a significant asset vehicle to leave alone until it’s necessary to take distributions from them.
There are, of course, going to be a lot of variables for everyone’s retirement withdrawal strategies, and there truly is no “one size fits all” with this. Taking personalized advice from a financial advisor is the best way to create an effective plan for drawing down on accounts in retirement.