Saving is Easy, Withdrawing is Hard
When it comes to building long-term wealth, where you hold your investments is just as important as what you invest in.
Choosing the right account type determines how your growth is treated over time and how much of your money stays in your pocket when you start taking withdrawals. Below is a simple breakdown of the three primary account types—Traditional IRAs, Roth IRAs, and Taxable Accounts—and how taxes work for each during both the growth phase and withdrawal phase.
Imagine a client (60 years old) who is in the 22% tax bracket. Many years ago they invested $300,000 into each of these three types of accounts. Today each account is worth $500,000 and the client is needing $75,000 for a major purchase. So let’s take a look at the tax implications of withdrawing the funds from each type of account.
1. Traditional IRA (Tax-Deferred)
For a traditional IRA, money goes in pre-tax (or is tax-deductible), grows without ongoing tax drag, and is taxed as ordinary income upon withdrawal. In this example, the client takes a distribution of $91,500 gross, pays $16,500 in federal taxes netting $75,000.
The entire gross distribution of $91,500 is added directly to their taxable income for the year and taxed at federal income tax of 22%.
Gross Distribution: $91,500 Taxes: $16,500
2. Roth IRA (Tax-Free)
In a Roth IRA, you contribute dollars you have already paid taxes on today. In exchange, your money grows tax-free, and qualified withdrawals are 100% tax-free. In this case, the client receives the full $75,000 without owing a single dollar in federal or state income taxes. This withdrawal does not affect their adjusted gross income (AGI) or tax bracket for the year.
Gross Distribution: $75,000 Taxes: $0.00
3. Taxable Account Withdrawal
Withdrawing $75,000 from a taxable brokerage account is not fully taxed because you are simply taking out your own funds. Instead, tax is calculated only on the proportional capital gain embedded in that withdrawal. Based on your total account value of $500,000 ($300,000 cost basis + $200,000 gain), the account is 60% principal and 40% growth. Thus, selling enough assets to net $75,000 triggers a taxable gain of $30,000 (40% of $75,000), while the remaining $45,000 is a tax-free return of your original basis. If you held the underlying investments for over a year, that $30,000 is taxed at preferential long-term capital gains rates, typically 15% rather than ordinary income rates, equaling $34,500.
Gross Distribution: $79,500 Taxes: $4,500
Strategic Takeaway: Tax Location & Diversification
In this example, we only explained what the tax situation would be if all the funds were taken from only one account. However, you are able to take funds from more than one account for a transaction. Thus, having a mix of these account types creates tax diversification in retirement. By strategically pulling funds from a combination of Traditional, Roth, and Taxable accounts, you can help optimize your annual tax bracket and manage your overall tax footprint.
This article is provided for informational and educational purposes only and should not be construed as investment, tax, legal, or accounting advice or a recommendation to buy, sell, hold or withdraw assets from an account. It should not be relied upon as the sole basis for a financial decision. The tax treatment of withdrawals from taxable accounts, traditional IRAs, Roth IRAs, and other investment vehicles depends on an individual's specific circumstances, including income level, age, tax filing status, holding periods, contribution history, state tax laws, and other factors. Investors should consult with a qualified tax professional before making any decision regarding distributions, withdrawals, conversions, or other tax-related strategies. Tax-efficient withdrawal strategies may not be appropriate for all investors and may involve trade-offs that should be evaluated in light of an investor's overall financial objectives, risk tolerance, liquidity needs, and estate planning considerations.