Understanding the tax implications of various investment accounts is essential for effective financial planning.
As a financial advisor, I frequently navigate these complexities for my clients to minimize tax liability when they withdraw funds, while aiming to keep their overall portfolio allocation intact.
Whether a client is making regular withdrawals throughout retirement or taking a one-time distribution to fund a significant goal such as a home renovation, mitigating the taxes triggered by these transactions is crucial.
Let’s break down how Roth accounts, traditional retirement accounts, and taxable brokerage accounts are taxed, and what this means for you when it’s time to access your money.
Tax Breakdown for Roth IRA, Roth 401(k) Accounts
Roth IRA and Roth 401(k) accounts are unique because of their tax treatment. You contribute post-tax dollars, meaning you don’t get a tax deduction when you make your contributions.
However, one of the key advantages of Roth accounts is that any growth in these accounts is tax-free, and withdrawals in retirement are also tax-free, provided certain conditions are met.
Let’s explore the basics of Roth IRA withdrawals.
Roth IRA Tax-Free Withdrawal Requirements
To qualify for tax-free withdrawals from a Roth IRA, the following conditions must be satisfied:
- Contributions: You can always withdraw your net contributions from a Roth IRA tax-free and penalty-free. To be clear, this would be your original dollar amounts you transferred into the account, and would not include any gains.
- Earnings: To withdraw from the earnings in the Roth IRA, the following requirements must be met:
- The Five-Year Rule: The Roth IRA must have been open for a minimum of five years. This five-year period starts on January 1 of the tax year in which you made your first contribution, regardless of whether it was made at the beginning or end of the year.
- Age Requirement: You must be at least 59½ years old to make tax-free withdrawals of Roth IRA earnings. Withdrawals made before this age may be subject to taxes and a 10% early withdrawal penalty on the earnings portion.
Exceptions to the Age Requirement for Roth IRA Withdrawals
There are exceptions to the age requirement rule, allowing for tax-free and penalty-free withdrawals of Roth IRA earnings for those under age 59 ½.
- People who have become disabled
- Heirs of a Roth IRA upon the death of the original account holder
- First-time homebuyers (up to $10,000).
What this means for you
When you withdraw from a Roth account in retirement, you won’t owe any additional taxes. This can be especially beneficial if you expect to be in a higher tax bracket in the future or if you want to avoid pushing yourself into a higher tax bracket in any given year that you need to withdraw more than usual during your retirement years.
The tax-free nature of Roth withdrawals may make them an excellent tool for managing taxable income in retirement. (While there are situations where tax-free withdrawals can be made from Roth accounts before retirement, I typically advise against doing so unless truly necessary. There are significant benefits to keeping as much money in the account as possible in the long term).
How a Traditional IRA, 401(k) is treated for taxes
Traditional IRA and 401(k) accounts operate very differently from Roth accounts.
Contributions to these accounts are typically made with pre-tax dollars, allowing you to lower your taxable income in the year you contribute. The trade-off is that when you withdraw from these accounts, the full value of the distributions is considered ordinary income and is subject to your income tax rate at the time of the withdrawal.
Early Withdrawal Penalties: If you take distributions from a traditional IRA or 401(k) before reaching the age of 59½, these withdrawals are generally subject to a 10% early withdrawal penalty in addition to regular income taxes, though there are some exceptions to the early withdrawal penalty.
Exceptions to Early Withdrawal Penalty for Traditional IRA, 401(k)
- Disability: If the account owner becomes totally and permanently disabled, they may withdraw from the account without penalty.
- Medical Expenses: Funds may be withdrawn from the account without penalty to pay unreimbursed medical expenses above 7.5% of Adjusted Gross Income (AGI)
- Birth or Adoption: Up to $5,000 per child may be withdrawn from the account without penalty.
- Qualified Reservist Distributions: Certain active military reservists may withdraw from the account without penalty.
- Substantially Equal Periodic Payments (SEPP/72t): If the owner of the account starts making annual withdrawals of substantially equal amounts over the course of their lifetime, they can start withdrawing early without penalty. This is a key rule for individuals planning to retire before age 59½.
- Qualified Higher Education Expenses: Funds withdrawn to pay for tuition, fees, books, and supplies for the higher education of the account owner, their spouse, child or grandchild may be withdrawn without penalty. This exception is only for IRAs and not 401(k)’s.
- First-Time Home Purchase: The account owner may withdraw up to a lifetime maximum of $10,000 without penalty to help pay for their first home. This exception applies only to IRAs and not 401(k)’s.
- Separation from Service (Rule of 55): If the account owner leaves their job in or after the year they turn 55, they may start withdrawing from their 401(k) early without penalty. This exception only applies to 401(k)s and not IRAs.
What this means for you:
Withdrawals from traditional accounts may create a significant tax liability in retirement. It’s important to plan ahead to avoid unnecessarily pushing yourself into a higher tax bracket when you start taking distributions.
Unlike Roth IRAs, Traditional IRAs involve Required Minimum Distributions (RMDs), which begin at age 73 (for those who turn 73 before 2033) or age 75 (for those born in 1960 or later). What does an RMD mean? Whether you need the funds or not, you’ll have to withdraw a certain percentage annually and pay taxes on those withdrawals. Coupled with the fact that withdrawals are taxed, RMDs may complicate your tax picture.
How are Brokerage Accounts Taxed?
Simply put, a brokerage account is a catch-all term for a standard investment account that doesn’t fall under another classification, such as a Roth IRA, 529 account, or 401(k).
Let’s say you open an account on a platform like Robinhood or Fidelity to trade individual stocks. If you opened an investing account on one of these platforms and didn’t specify an account type, you’d likely be opening what we call a brokerage account.
Now, because a brokerage account is just a standard fare investment account, it doesn’t offer the same tax advantages as retirement accounts. But they do provide more flexibility.
For those who need to withdraw funds from their portfolio while they are still working — let’s say you wanted to buy a house or had a large, unexpected medical bill — taking withdrawals from a taxable brokerage account is often the best option. This is especially true for those under age 59½, as it allows them to avoid the penalties typically associated with early distributions from retirement accounts.
One of the significant benefits of using taxable brokerage accounts for withdrawals is that it enables your retirement accounts, such as Roth IRAs, Traditional IRAs, or 401(k)s (Roth or Traditional), to continue growing.
However, the drawback is that any income generated from investments in a taxable brokerage account is subject to taxes in the year it is earned, regardless of whether or not you make withdrawals from the account:
- Interest Income: Interest earned from savings, bonds, or other fixed-income investments is taxed as ordinary income at your regular income tax rate.
- Dividends: Dividends can be either qualified or non-qualified (ordinary). Qualified dividends are taxed at the lower long-term capital gains rate, which ranges from 0% to 20% depending on your income level. Non-qualified (ordinary) dividends, on the other hand, are taxed as ordinary income at your regular tax rate.
- Capital Gains: When you sell investments for a profit, you incur capital gains. If you held the investment for more than one year, it’s considered a long-term capital gain, which is taxed at the more favorable long-term capital gains rate (0%, 15%, or 20%, based on your income). If you held the investment for less than one year, it’s considered a short-term capital gain, and you are taxed at your ordinary income tax rate.
What this means for you
The tax rate for long-term capital gains is generally lower than the rate for ordinary income, which may make these accounts attractive for strategic withdrawals.
The tax consequences of withdrawing from a brokerage account come down to the gains and the amount of time you’ve held the shares. As long as you’re not liquidating an entire account, you can strategically sell investments to limit the amount of capital gains or prioritize investments that fall under long-term capital gains.
Leveraging Coordinated Withdrawal Strategies from Investment Accounts
We’ve covered a lot of ground in this piece, and unfortunately, the rules we’ve discussed are subject to changes in legislation. Consequently, developing a comprehensive strategy for investing and withdrawing across your various accounts can be a significant challenge to manage.
That’s where a financial advisor can come into the picture. Whether you want the peace of mind that you’re making the right choices or you just want to offload the mental burden of investing, a financial advisor can help you build a strategic withdrawal plan that considers the tax characteristics of each account type. This coordinated approach helps minimize your overall tax burden.
- Blended Withdrawals: To manage your tax liability, advisors often recommend a blended strategy. This involves withdrawing some funds from traditional retirement accounts and others from Roth or taxable accounts. By balancing the sources, you can keep your taxable income in a lower bracket while meeting your spending needs.
- Timing Withdrawals: Advisors may plan withdrawals to take advantage of years when your income is lower. For instance, strategic Roth conversions in lower-income years can help spread out tax liability over time without spiking your tax rate.
- Managing RMDs: For clients nearing 73, managing RMDs is essential. In some cases, converting portions of a traditional IRA to a Roth IRA before RMDs begin can reduce the tax impact of future withdrawals.
Why Tax Planning Matters
The difference between a well-optimized withdrawal strategy and a poorly planned one can mean paying thousands more in taxes over your retirement. By working with a financial advisor, you can create a thoughtfully crafted financial plan that considers your expected income needs, anticipated tax rate changes, and the nuances of each account type. This proactive approach ensures you’re making the most of your hard-earned savings and protecting your future financial health.
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About the Author
Carla Adams is a CERTIFIED FINANCIAL PLANNER® practitioner who specializes in helping women build strong financial plans around their equity compensation, including Restricted Stock Units (RSUs). With over 15 years of experience in financial services, Carla has in-depth knowledge and expertise geared toward helping clients with complex financial situations. She enjoys boiling down complicated scenarios through practical examples and down-to-earth conversations.