A. A typical retiree may have three types of investment account - taxable, tax-deferred, and tax-exempt. Each has an important, but different, role to play in helping manage tax exposure in retirement. We will review each of them in details below.
Taxable accounts include your bank and brokerage accounts. Any earnings from these accounts, including interest, dividends, and realized capital gains, are generally taxed in the year they’re generated. In the case of capital gains, keep in mind that any increase in value of the accounts’ investments, such as mutual fund shares or an individual stock, isn’t a taxable event in itself. It’s only when an appreciated investment is sold that the gain is realized; i.e., it generates a taxable capital gain or loss. When you own a mutual fund, however, capital gains may be realized by the fund manager and distributed to you - often subjecting you to a tax liability - even if you haven’t sold your fund shares.
Tax-deferred accounts include traditional IRAs, 401(k)s, 403(b)s, or SEP IRAs. Most, or all, of contributions to these accounts were made "pretax" which means that ordinary income tax on those contributions are owed when withdrawals are made in retirement. Any earnings from these accounts are also typically taxed as ordinary income when they’re withdrawn.
Tax-exempt accounts include Roth IRAs, Roth 401(k)s, and Roth 403(b)s. Contributions to these accounts are typically made with after-tax money, which means the contributions - and any earnings - are not taxable provided certain conditions are met.
It takes careful planning and a good strategy to maximize tax efficiency when you start taking money out of these accounts. We will discuss in the next blog post.