By Rusty Russell, CFP®, CKA®, CWS®, CEPA®
Most families we work with have spent decades building their financial resources. They have employer retirement plans, investment accounts, real estate, and maybe a business. By the time retirement is on the horizon, they have a solid sense of what they have accumulated. What is less understood, and often not thought about at all until it is almost too late to do much about it, is how differently each of those resources will be taxed when it is time to use them.
Understanding the three major categories of retirement income and how each is taxed is one of the most practical steps any family can take to help preserve what they have built.
1. Tax-Deferred: You Will Pay, Just Not Yet
The most common retirement savings vehicle in America is the tax-deferred account. Traditional IRAs, 401(k)s, 403(b)s, and most employer retirement plans fall into this category.
The word deferred is important here. It does not mean tax-free. It means the tax is postponed.
Money goes into these accounts before it is taxed. It grows without being taxed along the way. But when it comes out in retirement, every dollar is taxed as ordinary income in the year it is withdrawn. Required minimum distributions, which begin at age 73, mean that at a certain point, withdrawals are no longer optional.
For families who have saved diligently in tax-deferred accounts for decades, this can create a significant tax obligation in retirement, sometimes larger than expected, and sometimes arriving at an inconvenient time.
2. Fully Taxable: Paying as You Go
The second category includes assets held outside of retirement accounts. Checking and savings accounts, brokerage accounts, individual stocks and bonds, real estate investments.
These accounts are funded with after-tax dollars, and income generated within them is taxed in the year it is earned. Interest, dividends, and capital gains are all reported annually. There is no deferral here.
The tax rates that apply depend on the type of income. Ordinary income is taxed at regular rates. Long-term capital gains are often taxed at lower rates, which can be a meaningful advantage with the right planning.
3. Tax-Free: The Value of a Roth
The third category is the one most families have the least of, and the one that tends to be the most valuable in retirement.
Roth IRAs and Roth accounts inside employer retirement plans are funded with after-tax dollars. The money goes in already taxed, grows completely tax-free, and comes out in retirement without any additional tax owed, on either the contributions or the growth.
There are no required minimum distributions on Roth IRAs during the owner's lifetime. And because withdrawals do not count as taxable income, they do not affect Social Security taxation, Medicare premium surcharges, or tax bracket calculations.
For families who have the opportunity to build Roth savings, the long-term value is difficult to overstate.
Why It Matters: Managing the Bracket
We live in a progressive tax system. The first taxable dollars are taxed at the lowest rates. As income rises, it moves into higher brackets. That system resets every year.
Which means a family can be in the 24% bracket one year and the 10% bracket the next, depending entirely on where their income comes from.
That variability is not a problem. It is an opportunity. A family with assets in all three categories has flexibility. By managing which accounts to draw from and in what order, it is often possible to reduce the total amount that goes to taxes over a retirement, sometimes significantly.
The goal is not to avoid taxes entirely, but to pay them at the right time, at the right rate, and in the right amount. This way, more of what has been built can stay with the family and the causes they care about.
If you have never mapped out how your retirement accounts will be taxed or thought through the sequence of how you will draw from them, that is a conversation we would be happy to walk you through.