Understanding the Financial Basics of Retirement Accounts and Taxes
To make informed decisions, you first need to understand the landscape. Your retirement savings are likely held in different types of accounts, each with its own set of tax rules. Think of your savings as being in three distinct “buckets.”
The Three Tax Buckets: Tax-Deferred, Tax-Free, and Taxable
1. The Tax-Deferred Bucket (Traditional Accounts)
This is the most common type of retirement account. It includes Traditional IRAs, 401(k)s, 403(b)s, and other similar employer-sponsored plans. The deal with these accounts is simple: you get a tax break on the front end. Your contributions were often made with “pre-tax” dollars, meaning they lowered your taxable income in the year you made them. Your money then grew over the years without being taxed on dividends or capital gains.
However, the tax bill eventually comes due. When you withdraw money from these accounts in retirement, every single dollar—both your original contributions and all the growth—is taxed as ordinary income. This means it’s taxed at the same rates as wages or a salary.
Example: Let’s say you are in the 12% federal income tax bracket. If you withdraw $20,000 from your Traditional 401(k) to cover living expenses, you will owe $2,400 ($20,000 x 12%) in federal income tax on that withdrawal, plus any applicable state taxes.
2. The Tax-Free Bucket (Roth Accounts)
This bucket includes Roth IRAs and Roth 401(k)s. These accounts work in the opposite way of tax-deferred accounts. You contributed with “after-tax” dollars, meaning you received no upfront tax deduction. But the reward comes in retirement: all qualified withdrawals are 100% tax-free.
For a withdrawal to be qualified, you must typically be at least 59½ years old, and the account must have been open for at least five years. The tax-free nature of Roth withdrawals makes them an incredibly powerful tool in retirement, as they provide you with a source of income that won’t increase your tax bill.
Example: If you withdraw $20,000 from your Roth IRA (and meet the age and holding period requirements), you will owe $0 in federal income tax on that money.
3. The Taxable Bucket (Brokerage Accounts)
This bucket includes standard, non-retirement investment accounts, such as a brokerage account where you hold stocks, bonds, or mutual funds. You fund these accounts with after-tax money. When you sell an investment in this account, you only pay taxes on the profit or capital gain.
The tax rate you pay depends on how long you held the investment.
- Long-term capital gains: If you held the asset for more than one year, you pay taxes at lower long-term capital gains rates (0%, 15%, or 20% depending on your total income). Many retirees fall into the 0% or 15% brackets.
- Short-term capital gains: If you held the asset for one year or less, the profit is taxed at your ordinary income tax rate, which is much higher.
Example: You bought a stock for $5,000 five years ago in your brokerage account, and it’s now worth $8,000. If you sell it, you only pay tax on the $3,000 profit. If your income qualifies you for the 15% long-term capital gains rate, your tax would be $450 ($3,000 x 15%).
What Are Required Minimum Distributions (RMDs)?
The government allowed you to defer taxes on your Traditional IRAs and 401(k)s for decades, but it won’t let you do so forever. To ensure it eventually gets its tax revenue, the IRS mandates that you begin taking withdrawals, known as Required Minimum Distributions or RMDs, once you reach a certain age.
Thanks to the SECURE 2.0 Act, the starting age for RMDs is now 73 for individuals born between 1951 and 1959. It will rise to age 75 for those born in 1960 or later. Failing to take your full RMD on time results in a significant penalty—currently 25% of the amount you failed to withdraw. This is a costly mistake you want to avoid. Your RMD is calculated based on your tax-deferred account balance at the end of the previous year and a life expectancy factor provided by the IRS. Proper RMD strategies are a cornerstone of tax-efficient retirement planning.
