How Will Your 401(k) be Taxed in Retirement?
This video explains how our firm helps retirees manage taxes across multiple retirement accounts. Tim outlines the tax implications of pre-tax, Roth, and taxable accounts, and he discusses managing taxes and locations of investments for optimal tax efficiency in retirement.
How are your 401(k) and other accounts going to be taxed when you retire? At Eagle Ridge Wealth Advisors, we help people retire every day.
It's not unusual, at the beginning of a relationship, for us to meet with people and find out they have 6, 7, or 10 different accounts scattered around with different custodians. They may have had different employers and a few 401(k)s, and as they approach retirement, or summiting the proverbial retirement mountain, they wonder how to take all these accounts and turn them into an income stream in retirement without getting hosed in taxes.
That's exactly what we do. We help people mitigate that tax bomb in retirement.
The best way to talk about this is to realize that we are taxed on our income two separate ways:
- The first is our 7-bracket ordinary income rates that go from 10% to 37%.
- Then we have the more preferred beneficial 3-bracket system of qualified dividends and long-term capital gains.
3 Retirement Account Types
I'm going to take you through how those tax brackets work with the different accounts you could end up with in retirement. Even if you have multiple accounts spread out, if you consolidate, ultimately you'll probably end up with three account types. A lot of times, we like to start with consolidating accounts for new clients.
- You may have tax deferred accounts like 401(k)s, IRAs, maybe a 403(b). They are different account types, but if they're tax deferred, they're going to get taxed the same way.
- The second account type is a taxable account, like an individual or joint brokerage account. If you have capital gains in a taxable account, as long as you held the assets sold for over a year, you're going to have the beneficial tax rates in the 3-bucket system that, right now, are 0%, 15%, and 20%. That is much better than going from 10% to 37% on the ordinary income 7-bucket side.
- The third account type is your Roth accounts, like Roth IRAs or Roth 401(k)s. Those are your best accounts because, if you can get money into them and you the account is qualified, any money that comes out later down the road is going to be tax free. Of course, at my firm, we love Roth accounts to really help mitigate lifetime tax liabilities for our clients.
How the 3 Account Types are Taxed
The best way for me to illustrate how your account types are going to be taxed in retirement is for me to use a hypothetical situation of buying ABC stock. Let's say we think ABC stock is going to go up like it's the next Apple or whatever, so we're going to buy it.
Pre-tax Accounts
So what happens if you buy that stock in a pre-tax 401(k) or IRA? Let's say the stock goes from $10 when you bought it to $100. When you withdraw the money from your pre-tax account, you're going to be taxed at our 7-bracket system, and those are going to be our highest rates in the tax code right now. That's just how it is because it's a pre-tax account and when the money comes out, you have to pay Uncle Sam his share. You didn't pay any taxes when the money went in, so you're going to pay it coming out.
Taxable Accounts
Next let's say you bought ABC stock in an after-tax account. Again if you have gains in it and you've held it over a year then you're going to be in the preferred capital gains and qualified dividends brackets, and those rates are much better than our 7-bracket ordinary system and then third
Roth Accounts
What if ABC stock goes from $10 to $100 in the Roth account? The money is going to come out tax free. So again, that's your best account as long as you get it qualified. There are rules for that but the biggest thing is getting one open and getting it funded.
Losses in the 3 Account Types
Now that's what happens if we bring anything with gains out of those accounts.
But what happens if we have losses? Nobody likes losses, but your know they happen, and some firms and robo-advisors like to tout tax loss harvesting as a way to save a ton of money. We use tax loss harvesting as an important tool in our quiver to help mitigate lifetime tax liabilities, but the problem is you've lost money. Nobody likes to lose money. Tax loss harvesting is something we can use, but I tell people it's really more of a Band-Aid when what you need is a tourniquet or a cast. Because, like I said, you've lost money.
The best example I have for that is actually in 2022 at the beginning of the year. I had some good gains from previous years, so I had sold some stuff and I was going to be in a tax bracket that I didn't want to be in. At the end of that same year 2022, I had some losses in my personal account. I was able to sell in December and drop me back down into a lower bracket to avoid paying more taxes than was necessary. That is tax loss harvesting.
Of course, if you lose money in the other accounts, it's not going to make a huge difference. You just lost the money because in the pre-tax accounts, you're going to pay tax when the money comes out no matter what amount it is. And then in the Roth account, you've already paid tax on the money going in, so it's just going to come out at whatever amount you've gained or lost in that account.
Inheriting the 3 Account Types
The next thing that you want to consider is, God forbid, what happens when you die. Nobody likes to talk about it but this is stuff that we need to think about because it's going to affect your legacy.
Sometimes people don't care, and they say their heirs are going to get more money than they should, but if you had a choice of having more money go to your legacy, your kids, or Uncle Sam, what are you going to choose. I mean I would definitely choose my children, so this is how we need to think about this.
So let's say you pass away and you leave your beneficiaries or your children or your legacy your IRA or your 401(k) or any pre-tax account. Unfortunately, in 2020 the SECURE Act did away with the stretch IRA, which allowed inherited IRAs to be stretched over the heir's lifetime. This could keep the amount of money that had to come out of those accounts relatively low.
The SECURE Act said they now have to take that money out within 10 years, and that's kind of a phantom tax on the middle class. If statistically, people are passing away in their 80s or 90s, then they're passing that money onto their legacy in their 50s and 60s, typically when they're in their peak earning years. So now they have to take that money out within 10 years, and it just stacks on top of their peak earnings, so it's going to bump them way up in the tax brackets.
Unfortunately, if you haven't done any estate planning since 2020, you need to think about that, as well, because that really changed a lot of things, but it never hit the headlines because it wasn't a change in the brackets or the rates. When you heirs withdraw the money, it's going to be taxed at their 7-bracket ordinary income rates, not yours in retirement, which are probably lower.
In the taxable accounts, there is a Step Up in Basis. The way it works is if you have something that you bought at $10 and it goes to $100, and then God forbid you to pass away, it's just like your heirs bought it at $100. So they could sell it the next day at $100 and they would owe no tax on it, so step up in basis is a good thing in a taxable account.
Like I said, you're going to owe the 7-bracket system on the pre-tax account and then the Roth is going to be tax free, but there is a step up in basis in the after tax account.
Asset Location
I know you've probably heard the term location, location, location, right? Well, it also applies to your investments. Often when I meet with people, they're thinking about tax allocation, which is like as you approach retirement maybe you need to be a little bit more conservative and they talk about 50/50 or 60/40 or 70/30. This means equities to bonds or fixed income.
But we also need to think about laying the tax code on top of your retirement situation, so we need to think about asset location, as well. So remember that location, location, location. That means, if you're going to have ABC stock go from $10 to $100, which account do you want to put it in or hold that investment in?
Roth IRAs
You want to have your more growth oriented stocks be in your Roth account because if you have something go from $10 to $100, you want it to be in the Roth so you don't have to pay tax when it comes out.
Pre-tax Accounts
If you're going to have bonds or fixed income type holdings, then you're going to want to hold those in your pre-tax accounts, like your IRA or 401(k) because you're going to have to pay tax on that anyway when the money comes out. If you're going to have something that's going from $10 to maybe $20 instead of $100, you're going to want that in your pre-tax accounts because if you're going to have to pay tax on something anyway, you might as well put your conservative more steady investments in that account.
Taxable Accounts
Then you're going to want to take the stuff that's maybe slightly less growth oriented and put that in your taxable account, because once again, if you hold an investment with gains for over a year, then you're going to be in the 3-bracket system of long-term capital gains and qualified dividends, which is much better than the 7-bracket system.
If you're going to have ABC stock go from $10 to $100, first you would want it in the Roth account. The next level would be in the taxable account because you're going to get the preferential qualified gains and long-term capital gains tax brackets there.
So remember, when you're investing: location, location, location.
Bottom Line
Those are the three account types: tax deferred, taxable, and Roths with after tax or tax-free money. Once you realize how your accounts are going to be taxed, no matter how many you have it's all going to boil down to those three account types. This gives you a little bit about how to think about how to hold your investments so that you can mitigate lifetime tax liabilities in your retirement.
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