Dave Kennon, Kennon Financial
“Which account should I take the money from? I want to be as tax-efficient as possible.”
Common question. Let’s dive in.
Let’s say you find yourself retired with the following types of accounts:
3. Roth IRA
4. Mutual funds (outside of a retirement account)
5. Individual stocks and bonds (outside of a retirement account)
6. A checking account.
Let’s quickly review the tax-treatment for each. Current income and capital gains rates are included at the bottom of this article.
Contributions to IRAs are tax-deductible. Withdrawals are always taxed as income. You typically cannot withdraw money before age 59.5 without being assessed a 10% penalty.
You MUST begin withdrawals at age 70.5 (Required Minimum Distribution). At 70.5 you must withdraw 3.65% of your pre-tax retirement accounts. That required distribution increases each year. By age 80, you must withdraw 5.35% per year.
401ks receive the same tax-treatment as IRAs. The only difference? If you are still employed, you do not need to start taking mandatory distributions until you stop working.
The money you contribute to a Roth IRA is after-tax, so you get no tax deduction up front. But withdrawals from Roth IRAs are tax-free, as long as five years have passed since the tax year of your first Roth IRA contribution.
Mutual Funds (outside of a retirement account). You must pay income taxes each year on the dividends or interest paid. In addition, whenever you sell the positions you must pay capital gains on any growth in the fund.
You will never have to pay taxes on the principal because the money is already after-tax.
If you hold a mutual fund for less than a year, you will need to pay short-term capital gains tax (which is the same rate as income tax). If you hold it for more than a year, you will pay long-term capital gains.
Individual Stocks and Bonds (outside of a retirement account). They’re basically treated the same as mutual funds. You pay income taxes on the dividends and interest. You pay capital gains (long or short-term) when you sell.
Checking account. It’s pretty simple. Interest is taxed as income. Last year I made $3 in interest on my checking account, and I had to pay several cents in taxes.
So which account do you withdraw money from in various situations?
Let’s look at a few rules of thumb.
1. IRA, 401ks, and other pre-tax accounts are designed to pay out money stretched out over many years. They are NOT designed to withdraw large lump sums all at once. Remember that these accounts are taxed as income, and if you take out too much in any one year, you could bump yourself into a very high tax bracket.
Here’s a common mistake: Mr. Jones retires with $500,000 in his IRA, but he still owes $320,000 on his mortgage. So he decides to withdraw $320,000 to pay it off. Big Mistake.
All of that money is going to be taxed as ordinary income. Mr. Jones just found himself in a 32% tax bracket. He is going to get an unpleasant surprise when he files his tax return. By withdrawing $320,000 from his IRA, Mr. Jones could be responsible for $80,000 or more in taxes. Don’t do that.
It is far more tax-efficient to take a reasonable withdrawal each year (5% per year for example). This stretches out the tax liability and keeps your tax bracket lower.
2. Roth IRAs are generally the last type of account used. Why? They grow tax-free. They pass on to heirs tax-free. Sometimes it might make sense to withdraw money from a Roth IRA when you don’t want to add any more income to your tax return.
Example: Maybe you are currently receiving subsidized healthcare from the ACA. If you withdraw money from an IRA, it is viewed as income and could reduce your subsidy. Withdrawals from Roth IRA’s are not viewed as income which may allow you to continue to qualify for the subsidy.
3. Try not to sell mutual funds, stocks, or bonds within one year of purchase (assuming they are in a non-retirement account). Generally, long-term capital gains rates are much lower than income tax rates.
4. Don’t forget that stocks, bonds, and mutual funds all have a “step up in basis” feature (in non-retirement accounts). If you pass away, your heirs will not have to pay any income or capital gains taxes. When they do sell the positions, they only need to pay taxes on the amount the investment has grown since your passing.
For example, if your Dad has $100,000 in IBM stock, and he originally paid $10,000 for the shares, if he sells the stock he would have to pay $90,000 in capital gains taxes. But if he dies and leaves the stock to his son, the cost basis increases to the value of the stock on the date of death.
In other words, if his son sells the stock right away after receiving the inheritance, he would not have to pay any capital gains taxes. The original amount his Dad paid is “stepped-up” to what it was worth on the day of his death. So the new cost basis would be $100,000.
5. Lastly, a quick note about charitable giving. If you have stocks and bonds (outside of a retirement account) and they have significant gains, you can donate the appreciated stock to a charity without having to pay any taxes (nor does the charity). It is a great strategy to maximize your giving.
Dave Kennon, Kennon Financial