Understanding How Retirement Distributions are Taxed
During retirement, is it best to take distributions from IRAs, Roth IRAs or personal brokerage or savings accounts? The decision of "Which account?" is an important one with many factors to consider.
During the “accumulation” phase, the decision of where to invest your money is somewhat automated. Making contributions to 401(k) plans, Roth IRAs and personal brokerage or mutual fund accounts is pretty straight forward and can remain on auto pilot for years. However, for retirees taking money out of their investment accounts, the decision of “which account?” can be a bit more cumbersome. In fact, most retirees should reassess their distribution strategy on an annual or even semi-annual basis.
Why is this decision an important one? To answer this question, it is important to understand how distributions from various types of accounts are taxed. Consider the tax treatment from each of the following types of accounts:
IRAs and 401(k) Plans (qualified accounts)
Distributions from qualified retirement plans are considered taxable income. They are generally taxed to individuals (at their marginal tax rate) on a dollar for dollar basis.
Personal accounts (non-qualified accounts)
Personal brokerage accounts can be established at brokerage firms, mutual fund companies and banks. Income, interest and capital gains generated in these accounts are taxable in the year they are earned or realized.
If a stock or mutual fund is sold, the gain on the sale is a capital gain and is generally taxed at capital gains rates. Investment losses realized in personal accounts can be used to offset realized gains and up to $3,000 of taxable income. Because taxes are paid in the year income is earned or realized, distributions from personal accounts are not taxable.
Roth IRAs
Income, interest and capital gains realized in Roth IRAs are not taxable. In addition, distributions from a Roth IRA by those above the age of 59 1/2 (with some exceptions) are not taxable. From a tax standpoint, Roth IRAs are much more favorable than personal accounts or IRAs.
Tax Management
As you can see, each type of account has varying tax attributes. As such, with proper planning it is possible to effectively control, or at least manage, taxable income. In doing so, there are a number of other items that may be impacted including:
Taxability of Social Security
Deductibility of Medical Expenses
Cost of Medicare Part B Premiums
Overall Effective Income Tax Rates
Other Financial Planning Considerations
While it is important to consider the tax impact when developing a retirement distribution strategy, there are times when it is appropriate to take a more holistic approach. This is particularly important when making multi-generational and estate planning decisions. Consider the following example:
You are 65 years of age and are currently in the 15% marginal tax bracket. You have designated your son, as the beneficiary of your IRA. As the owner of a successful business, your son expects to remain in the highest tax bracket and has never been able to contribute to a Roth IRA.
Together, you decide that it is appropriate to execute a Roth conversion strategy, whereby you convert a portion of your IRA into a Roth. In doing so, the distribution from your IRA is taxed to you at your lower tax rate. At your death, your son will inherit the Roth IRA and distributions would never be taxed.
As you can see, making tax-efficient distribution decisions during retirement can create significant tax savings for you and your family. It is important to understand the tax attributes of the assets you own for your peace of mind, as well as for your family.