A recent retiree asked this great question, and I thought it would be worth diving into some details on the topic.

To answer the question we need to understand what options a retiree has and how each option is taxed.

• Taxable investments: Taxable accounts (or just normal brokerage accounts) are taxed in two ways depending on the investments. Bonds and bond funds get most of their gains from interest, which is taxed as ordinary income. Stocks and stock funds can be taxed as capital gains if they are held for 12 months or longer. Capital gains are taxable when a position is sold. Stocks also pay dividends; if those dividends are qualified, then they are taxed as capital gains as well. Capital gains rates for most federal retirees fall in the 0% or 15% tax rate.
• Tax-deferred investments: These are accounts you have deferred taxes on and will be fully taxable when funds are withdrawn. Thrift savings plan and traditional IRAs fall in this category. Distributions are taxed as ordinary income.
• Tax-free investments: These are accounts you have already paid taxes on; when you take qualified distributions, those distributions are income-tax free. Roth TSP and Roth IRAs fall into this category.

It’s important to understand that each of these types of accounts have different benefits. Read on to discover some of the benefits of each type.

• Taxable accounts
  • Only gains are taxed when you sell a position. If you don’t have any gains, then there aren’t any taxes to pay. If you bought a position for $8 and it is worth $12 when you sell it, then you only pay taxes on the $4 gain. You can also do tax loss and gain harvesting with your taxable accounts.
  • Another big benefit to taxable accounts is that assets pass on to beneficiaries with a step up in basis. For example, if you put $50,000 into a taxable account and it grows to $400,000, then your beneficiaries receive a step up in basis to the value at your death.
• Tax-deferred accounts
  • The main benefit of tax-deferred investments is that you don’t pay taxes on the contribution when the investment is made. Retirees continue to receive tax deferral, but any distributions are 100% taxable.
  • Tax-deferred accounts also have required minimum distributions, which wouldn’t be considered a benefit. The benefits of tax-deferred accounts are realized during your working years and the tax deferral growth.
• Tax-free accounts:
  • The benefits of tax-free accounts are realized in retirement when distributions are income-tax free. If you are 59 ½ or older and have had the account for five years or longer, then any distributions are not taxed or penalized.

Having investments in each of the three categories above would give retirees some flexibility over the income tax they pay. Tax planning is a hot topic that can help you keep more of your money in retirement. But back to the big question: where do you pull funds from first?

The answer is, once again, it depends! My recommendation is to look at your taxable income for each year and process the data. Pulling funds from your brokerage account first would likely lead to paying lower taxes today, which means your tax-deferred accounts are going to continue to grow, but that also could result in higher taxes when any withdrawals are taken. The decision of where to withdraw from first is going to come down to several factors.

• What is your taxable income today?
• What is your taxable income in the future?
• Is lowering taxes today a priority?
• Is lowering future taxes a priority?
• Are you married or single?
• Do you have a desire to pass assets on to beneficiaries?

Consider these scenarios that demonstrate what your withdrawals might look like in a given year.

The retiree is currently in the 12% tax bracket and is expected to be for the next five years until they start collecting Social Security.

In this scenario, it is likely beneficial to withdraw from tax-deferred accounts. At a minimum, the retiree should withdraw to cover the remaining gap in the 12% tax bracket if they expect to be in the 22% tax bracket in the future.

The retiree is currently at the higher end of the 12% tax bracket and expects to remain there.

In this scenario, the retiree might want to do a small conversion to fill up the rest of the 12% tax bracket. A married retiree should consider the widow’s penalty and how that would affect the survivor.

The retiree is currently in the 22% tax bracket and expects to remain there until Required Minimum Distributions (RMDs) start.

This retiree has options since there doesn’t appear to be any big changes in the future. One consideration should be withdrawing from tax-deferred accounts to reduce future RMDs. Withdrawing from a brokerage account would keep taxable income lower today.

The retiree is currently in the 22% tax bracket and expects to be in the 12% tax bracket in the future.

This situation is very rare; the only time I’ve seen it happen is when one spouse is still working. This retiree may want to take withdrawals from a brokerage account or even tax-free accounts to reduce taxes today.

The retiree is currently at the higher end of the 24% tax bracket.

In this scenario, it may make sense to withdraw funds from tax-free accounts once you hit the tip of the 24% bracket. The next tax bracket is up to 32%.

Your choice of where to withdraw funds from in any given year of retirement comes down to your priorities for your current and future taxable income. Once you identify your criteria, it becomes easier to pinpoint the account you will withdraw from. I specialize in these retirement details at Bobb Financial. Schedule a call today if you would like help on your retirement journey.