Prefer to listen rather than read? Pair this post with Deliberate Money Moves Podcast: Consider Taxes When Making Withdrawals.
Actually Using Your Savings
I know that might sound odd as we tend to save throughout our working life and even sometimes well into our retirement years. But there will be times you need to withdraw your savings and it’s important to consider the tax implications.
3 Types of Savings Accounts
- Taxable accounts are your regular savings and investment accounts where you are paying tax today on any investment earnings or realized gains.
- Tax-deferred accounts are traditional IRAs and traditional 401ks where you are deferring income tax into the future when you eventually take money out.
- Never-taxed again accounts are Roth accounts where, assuming you follow the rules, you will never have to pay tax on anything you take out.
Your first step is to know how much you have in each of these and understand the tax consequences of withdrawals.
For example, if you have a Roth account you might be able to take some of the funds out today even before you are 59 and a half without any tax consequences. This comes from the 5-year rule which basically states that once funds have been in the account for five years, you can pull your contributions out with no tax or penalty. Be sure to confirm this is the case for you before considering this as a strategy.
Another example of understanding your tax consequences is to look at your taxable account to see if you have anything you would sell that would be at a loss or a small gain. Selling these investments for withdrawals might not cost you anything tax-wise.
Once you know the tax consequences of all your funds, consider withdrawing first from the investments that leave the most in your accounts to continue to grow. In other words, consider the funds with the lowest tax consequences. This allows you to withdraw less today and keep more invested and growing for your future. Sounds pretty simple. Just use the funds that create the lowest amount of taxes.
However, Consider This
Our tax laws are always changing, and investment accounts are a huge target for Congress as they continue to fund excess spending. This means at times the laws will favor withdrawing from one type of account and at times they’ll favor another.
So, a good strategy is to try to have some significant balances in each of the three tax types: taxable, tax-deferred and already-taxed.