A key to managing taxes in retirement is understanding the tax treatment of different types of investment accounts. There are three types of accounts from a tax perspective:

Taxable Accounts

These consist mainly of brokerage accounts. Taxes are due on investment gains during the year when investments are sold. If investments are held for less than one year, gains are taxed at the seller’s ordinary income tax rate. If investments are held for one year or longer, they are taxed at favorable capital gains rates of 0%, 15% or 20%, depending on the seller’s adjusted gross income.

Tax-Deferred Accounts

These accounts include traditional IRAs and 401(k)s. Taxes aren’t paid until funds are withdrawn in retirement, at which time withdrawals are taxed at ordinary income tax rates. Many people’s tax rates are lower in retirement than during their working years.

Tax-Free Accounts

These include Roth IRAs and Roth 401(k)s, which are funded with after-tax dollars. This means taxes have already been paid, so funds can generally be withdrawn tax-free in retirement. Tax-free accounts are often among the most beneficial retirement accounts from a tax standpoint.

Which Accounts Should You Withdraw From First? 

If you have money in all three types of accounts, one strategy is to withdraw funds from your taxable accounts first, your tax-deferred accounts second, and your tax-free accounts last. This may allow your tax-advantaged funds more time to potentially grow.

Alternatively, you may choose to withdraw funds proportionally from all account types. This approach could help stabilize your tax bill throughout retirement. The most appropriate strategy depends on your unique financial situation, income needs, and long-term goals.

Required Minimum Distributions (RMDs)

Can a Roth Conversion Help Reduce Future Taxes? 

RMDs can potentially be reduced or avoided by converting traditional IRA or 401(k) assets to a Roth account. However, income taxes are generally due on the converted amount in the year of the conversion.

While a Roth conversion can be an effective long-term tax-planning strategy, it should be carefully evaluated within the context of your current tax bracket, future income needs, and overall financial plan. Additionally, if you are already subject to an RMD, the current year’s RMD generally must be taken before completing a Roth conversion.

Will You Pay Taxes on Social Security?

If you continue earning income after retirement, a portion of your Social Security retirement benefits may be subject to federal income tax.

To determine whether your benefits may be taxable, the IRS uses a calculation called provisional income. This includes:

• Your adjusted gross income
• Nontaxable interest income
• One-half of your Social Security benefits

For some retirees, up to 50% of Social Security benefits may be taxable. For others with higher provisional income, up to 85% of benefits may be subject to federal income taxes.³

Taxes can be withheld directly from your Social Security benefits by filing IRS Form W-4V. Alternatively, retirees may choose to make quarterly estimated tax payments to avoid unexpected tax liabilities.

Plan Ahead for a More Tax-Efficient Retirement

Taxes can have a significant impact on retirement income and long-term financial security. By understanding the differences between taxable, tax-deferred, and tax-free accounts, planning for required minimum distributions, evaluating Roth conversion opportunities, and considering the taxation of Social Security benefits, you can make more informed decisions about your retirement income strategy.

The earlier you begin planning, the more opportunities you may have to manage taxes and maximize the resources available to support your retirement lifestyle.