How 3 Account Types are Taxed and Used to Lower Taxes
The type of account where you invest your retirement savings affects how withdrawals, gains, losses, and eventually inherited assets are taxed.
A question I get all the time from people who are close to retirement, or who are already in it, is: "Tim, I've saved a lot of money. Now how do I actually pull it out without getting hosed with taxes?"
The answer is very important if you want to pay as low a tax rate as possible in your retirement. If you’ve saved a million dollars or more, where your money is sitting, or what type of account it’s in, matters almost as much as how much you have. At least as far as taxes go.
Most people spend decades thinking about investment risk, returns, equities, and bonds, but they never once stop to ask: "Wait… am I holding the right assets in the right accounts?"
Are you? Have you laid the tax code on top of your retirement income situation to ensure you’re limiting your lifetime tax liability?
Today, I’m going to walk you through something that can have an immediate impact on your retirement tax situation, because understanding the three types of accounts and how each one treats your money differently when it comes to taxes can have a huge impact on a 10, 20, or 30+ year retirement.
The 3 Account Types
Let's start with the basics because there are a few things to understand before we go any deeper.
When you build a retirement nest egg beyond Social Security, a pension, or any other income sources, your savings are in one of three buckets or account types.
1. Pre-tax accounts
Think 401(k)s, 403(b)s, traditional IRAs. You contributed money before paying income tax on it, which felt great at the time. But Uncle Sam hasn't forgotten. Every dollar you pull out in retirement gets taxed at your ordinary 7-bracket income tax rates.
2. Taxable (after-tax) accounts
These are your individual brokerage accounts, joint accounts, anything outside a retirement plan wrapper. You already paid income tax on the money you put in. But now when you sell something at a gain, that creates a taxable event. If you’ve owned the asset sold for over one year, it qualifies for the preferential 3-bracket long-term capital gains rates, which are much better than ordinary income tax rates. More on that in a minute.
3. Roth accounts
This is the crown jewel. You contributed after-tax dollars, the money grows completely tax-free, and qualified withdrawals in retirement come out with zero federal tax. If we can get money into a Roth account, that is generally a very good thing.
Now, here's what most people miss: every time you choose where to put your retirement contributions, you are making a tax decision. You just may not have realized it at the time.
So why does it matter which account type holds which investments? Because the tax code treats gains, dividends, and withdrawals differently depending on the account type.
A stock that grows from $10 to $100 can produce three completely different tax outcomes - the same investment, just held in a different account.
Let me show you exactly how that works. Let’s say we buy ABC stock. Why do we buy it? We think it’s going up, right?! Why else?
What Happens When ABC Stock Grows?
Let's say we buy ABC stock at $10, and it grows to $100. The tax outcome depends entirely on where you own it.
In a pre-tax account (IRA or 401(k))
When you eventually take that money out, every dollar - that total $100 - gets taxed as ordinary income. There's no special treatment. It goes right into ordinary income along with your Social Security, pension, or any other income you have in retirement.
And our current rates are the highest in the code. Our ordinary 7-bracket income tax rates run from 10% all the way up to 37% in 2026. So, if you thought you'd be in a low tax bracket in retirement, you need to run the numbers, because a large pre-tax account can push you higher than you expect. Sometimes quite a bit higher.
Right now, our tax rates are as low as they’ve been in 100 years, but as you may have noticed, our debt is going through the roof. So, do you think tax rates will go lower in the future? I’d say that’s highly unlikely at this point.
In a taxable brokerage account
If you hold ABC stock for more than one year, and then sell it, your gain is taxed at long-term capital gains rates, not ordinary income rates. Those rates are significantly more favorable. Deductions aside, in 2026, if your taxable income is under $49,450 as a single filer, or under $98,900 for a married couple filing jointly, you pay zero percent on that capital gain.
Anything above those thresholds, you're looking at 15%. And the 20% rate doesn't kick in until well over $500,000 of income. That is a huge difference compared to ordinary income rates. That's why asset location, or deciding which investment is held in which type of account, is such a powerful planning tool.
In a Roth account
If ABC stock goes from $10 to $100 inside a Roth IRA or Roth 401(k), and you take a qualified distribution in retirement, you pay nothing. Zero. The growth is entirely tax-free. That's why we are such big fans of Roth accounts.
What Happens if ABC Stock Loses Value?
Nobody likes to talk about losses. But let's be honest – it happens. Markets go down sometimes. The tax treatment here is also very different depending on your account type.
In a pre-tax account or a Roth account
In your IRA or Roth IRA, a loss doesn't really help you from a tax standpoint. Your traditional IRA withdrawals are still ordinary income no matter what, and your Roth is still tax-free. The loss just hurts, but hopefully, you move on.
In a taxable brokerage account
In your taxable brokerage account, a loss gives you a tool called tax-loss harvesting. Here's how it works: if ABC stock goes down, you can sell it, lock in that loss on paper, and use it to offset gains elsewhere. You can even offset up to $3,000 of ordinary income per year, with any excess carrying forward to future years.
I want to be honest with you here: Tax-loss harvesting can be a useful arrow in the quiver, but it's not something I personally celebrate. Think about it - you've still lost money. Harvesting the loss is more like putting a bandage on a wound than cure. But when losses happen - and they will - we make sure to use them strategically.
So, when the markets are rough, and you have a loss in ABC stock or whatever, and you’re staring down a tax bracket you don’t want to be in, you might want to sell your losses and use them to offset any gains you may have had from earlier in the year.
What Happens When You Pass the Money On?
This is where a lot of families get blindsided, and it's something you absolutely need to plan for.
Pre-tax accounts and the inherited IRA "tax bomb"
When you pass away and leave a pre-tax IRA or 401(k) to a non-spouse beneficiary, the SECURE Act requires them to fully withdraw that account within ten years. No more stretching it over their lifetime, unfortunately. Here's the painful part: statistically, when parents pass away, their adult children are often in their 50s or 60s - their peak earning years.
So now your kids are forced to pull that pre-tax money out, on top of their salary, in the highest-earning decade of their lives. That's what we call the inherited IRA tax bomb. It’s pretty annoying because it’s basically a shadow tax on the middle class. If you haven't reviewed your estate plan since 2020 when the SECURE Act took effect, you should.
Taxable accounts and the step-up in basis
Step-up in basis is a good piece of news. If you hold appreciated investments in a taxable brokerage account and you pass away, your heirs inherit those assets at the current market value - not what you originally paid.
So, if you bought ABC stock at $10 and it's worth $100 when you pass away, your heirs' cost basis is reset to $100. They could sell it the next day and owe no capital gains tax at all. That's called a step-up in basis, and it's still one of the most powerful estate-planning tools available.
Roth accounts
Roth IRAs are great accounts to leave behind: Inherited Roth IRAs are still subject to the 10-year rule under the SECURE Act. But here's the key difference: the money comes out tax-free. There's no tax bomb. If you can leave Roth dollars to your heirs and let that money grow for as long as possible inside the account during that 10-year window, you're giving them a genuinely tax-free inheritance. That’s a solid gift - hopefully they deserve it, right?!
Bottom Line
Here's what I want you to walk away with: your accounts are not all created equal from a tax standpoint.
- Pre-tax accounts give you a break today but come due later, and can create a tax bomb.
- Taxable accounts can be surprisingly efficient with the right assets and holding periods.
- Roth accounts are as close to a tax-free gift as the IRS will give you.
The smartest retirement plans don't just ask how much you've saved; they ask where it's saved and how it's going to come out. Get your accounts working together in a tax-efficient way, and this can make a huge difference in what you actually keep.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.