As you’ve been building your nest egg over the past 30-plus years, your focus has been to invest as much as possible in tax-advantaged accounts (e.g., 401k, IRA, etc.). After you saved the maximum allowed each year to these accounts, additional money was invested in taxable/non-retirement accounts. This approach made perfect sense as you wanted to not only lower your taxable income but also get the benefit of tax-deferred growth.
Once you retire, now comes the time when you have to start drawing on these assets to cover your retirement expenses. And which accounts you tap first is very critical as you want to preserve the tax-deferred benefits of your money for as long as possible while at the same time minimizing the tax impact associated with selling assets. With that said, the order you want to sell your invested assets in various account types is as follows:
- Taxable/non-retirement accounts. Any long-term capital gains in these accounts are taxed at 15% for people in the 35% or below tax bracket. If you’re in the 15% or below tax bracket, long-term capital gains are tax free. Furthermore, you’ve been paying taxes on reinvested dividends and capital gain distributions since you’ve owned the investment. Because you’ve already paid taxes on these distributions, your higher tax basis in the investment will reduce the amount of capital gains tax you’ll have to pay.
- Nondeductible IRA or after-tax 401k/403b. Investments in these accounts were made with after-tax dollars, which means you’ll only be taxed on the deferred earnings. That’s the good news. The bad news is the taxable deferred earnings are considered ordinary income and taxed at your highest rate. For example, if you’re in the 33% tax bracket when you take the money out, your deferred earnings will be taxed at 33%. Note: You can always rollover your 401k or 403b to an IRA and take out 100% of the after-tax contributions tax free.
- Pretax 401k/403b/457b or deductible IRA. In these accounts, 100% of the amount withdrawn, including earnings, is taxable since none of the money was ever taxed. Remember that tax break you got up-front when you invested money in these accounts? Now comes the time when the IRS gets to tax all of it as ordinary income at your highest tax rate.
- Roth 401k/403b/457b or IRA. Even though distributions from these accounts are tax free, taking money from a Roth should be a last resort. I know that may sound counterintuitive, but the benefit of tax-free compounding is very beneficial—not only to you when you need the money in your late 80s but also to your heirs who will inherit this money tax-free.
Keep in mind that mandatory distributions for all retirement accounts, with the exception of a Roth IRA or 401k/employer-based retirement plan if you’re still working, is required at age 70 ½. By law, you’re required to take a certain percentage out each year, based on your age, or you’ll be penalized 50% of the amount not withdrawn. If you’re taking mandatory distributions anyway, use this money first to satisfy you income needs before selling assets in your taxable/non-retirement or Roth IRA accounts.